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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-KSB
[x] Annual Report For the Fiscal Period Ended December 31, 1996 Pursuant to
Section 13 or 15 (d) of the Securities Exchange Act of 1934
or
[ ] Transition Report Pursuant to Section 13 or 15 (d) of the Securities
Exchange Act of 1934
COMMISSION FILE NUMBER 001-12281
DIGEX, INCORPORATED
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(Exact name of small business owner as specified in its charter)
DELAWARE 52-1986462
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(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
ONE DIGEX PLAZA, BELTSVILLE, MD 20705
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(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) ZIP CODE
(301) 847-5000
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(REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE)
SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT: NONE
SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT:
COMMON STOCK, PAR VALUE $.01
(Title of each class)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934
during the preceding 12 months (or for such shorter periods that the registrant
was required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes [x] No [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [ ]
Revenues for fiscal year ended December 31, 1996 were $15,573,393.
The aggregate market value of voting Common Stock held by non-affiliates of the
registrant was approximately $53,762,166 as of March 26, 1997.
There were 11,294,922 shares of Common Stock outstanding as of March 26, 1997.
Transitional Small Business Disclosure Format: Yes No X
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DOCUMENTS INCORPORATED BY REFERENCE
Certain information in DIGEX, Incorporated's definitive Proxy Statement for its
1997 Annual Meeting of Shareholders, which will be filed with the Securities and
Exchange Commission pursuant to Regulation 14A not later than April 30, 1997, is
incorporated by reference in Part III of this Form 10-KSB.
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INDEX
PART I. PAGE
Item 1. Description of Business 3
Item 2. Description of Property 17
Item 3. Legal Proceedings 17
Item 4. Submission of Matters to a Vote of Security Holders 17
PART II.
Item 5. Market for Common Equity and Related Stockholder Matters 17
Item 6. Management's Discussion and Analysis of Financial Condition
and Results of Operations 19
Item 7. Financial Statements 24
Item 8. Changes In and Disagreements With Accountants on Accounting
and Financial Disclosures 38
PART III.
Item 9. Directors, Executive Officers, Promoters and Control Persons;
Compliance With Section 16(a) of the Exchange Act 38
Item 10. Executive Compensation 38
Item 11. Security Ownership and Certain Beneficial Owners and
Management 38
Item 12. Certain Relationships and Related Transactions 38
PART IV.
Item 13. Exhibits and Reports on Form 8-K 39
SIGNATURES 40
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PART I
ITEM 1. DESCRIPTION OF BUSINESS
When used in this Report, the words "estimate," "project," "intend" and
"expect" and similar expressions are intended to identify forward-looking
statements. Such statements are subject to risks and uncertainties that could
cause actual results to differ materially. For a discussion of certain of such
risks, see "Investment Considerations" in this Item 1, as well as other
information contained in this Report and in the Company's periodic reports
and other documents filed with the Securities and Exchange Commission. Readers
are cautioned not to place undue reliance on these forward-looking statements,
which speak only as of the date hereof. The Company undertakes no obligation to
publicly release updates or revisions to these statements.
INTRODUCTION
DIGEX, Incorporated ("DIGEX" or the "Company") is a leading independent
national Internet carrier that focuses exclusively on businesses, government
agencies and other institutional customers ("Business Customers"). The Company
offers a comprehensive range of Internet solutions, including a complete product
line of dedicated Internet connectivity solutions to its Business Customers, Web
site management, consulting and security, and private network solutions.
The Company was founded and incorporated in 1990 by a group of Internet
pioneers, as a local provider of dial-up Internet connectivity. After receiving
its first major infusion of institutional equity capital in March 1995, the
Company reoriented its strategy to focus exclusively on Business Customers that
generally require high bandwidth connectivity, and began to develop its Web site
management business. Additionally, the Company brought in an experienced
management team in the first quarter of 1996. The Company completed the initial
public offering of its Common Stock in October 1996. In January 1997, the
Company acquired, for approximately $0.8 million in cash, the assumption of
approximately $20,000 of indebtedness, and the issuance of 175,000 warrants to
purchase shares of the Company's Common Stock, Electronic Press Services Group
("EPSG"), a prominent integrator of electronic commerce solutions for high
functionality, complex Web sites. The Company's Business Customers have grown
from approximately 500 accounts at December 31, 1995 to approximately 1,505
accounts at December 31, 1996.
The Company offers its Internet solutions through three separate and highly
focused business units. The Business Internet Connectivity Group offers
dedicated high-bandwidth Internet connectivity and security solutions for
commercial Internet and Intranet communication applications. The Web Site
Management Group provides fault tolerant Web site management and electronic
commerce integration services to companies seeking to outsource the management
of "mission-critical" World Wide Web presences. The Private Network Solutions
Group seeks to create customized private label solutions for businesses seeking
to provide Internet services without incurring the cost of building and managing
their own facilities.
INDUSTRY BACKGROUND
The Internet is a global collection of computer networks that enables
businesses, government agencies, other institutional customers and individuals
to communicate, access and share information and conduct business remotely. Use
of the Internet has grown rapidly since the early 1990s, due in large part to
increasing personal computer and modem penetration, the development of the World
Wide Web, the introduction of easy-to-use navigational tools and utilities for
the Web and the availability of informational, entertainment and commercial
applications. Technological advances relating to the Internet have occurred and
continue to occur rapidly, resulting in a more robust, lower-cost
infrastructure, improved security and increased value-added services and
content. International Data Corporation ("IDC") has estimated that the number of
Internet users will reach approximately 200 million in 1999, from approximately
56 million in 1995. While there has been significant media interest in the use
of the Internet by consumers, Business Customers currently account for a more
significant percentage of Internet use. According to IDC, approximately 71%, or
40 million, of the approximately 56 million Internet users in 1995 were
business-related users. Internet capabilities, including corporate Internet
sites, are becoming an increasingly important part of conducting business.
According to Netcraft, Ltd., the number of corporate Internet sites,
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defined as domain names ending in ".com", has increased from 4,912 in August
1995 to 407,250 in December 1996.
Because Internet and corporate Intranet solutions are increasingly achieving
"mission-critical" status, Business Customers are demanding advanced, highly
reliable solutions designed specifically for the needs of business. Furthermore,
as the use of the Internet expands, Business Customers are requiring that
providers offer a comprehensive range of services, including connectivity, Web
site management, consulting, security and other networking products and
services. Finally, Business Customers often require knowledgeable and highly
responsive sales and customer service representatives in order to determine
their optimal Internet strategy quickly and to resolve any problems with their
current solutions.
THE DIGEX SOLUTION
The Company provides a comprehensive range of Internet solutions that serve
the needs of Business Customers who often desire a responsive, single-source
provider of reliable, high-performance Internet connectivity and Web site
management products and services.
Business Internet Connectivity. DIGEX offers a complete product line of
dedicated Internet connectivity solutions to its Business Customers with a
variety of service and pricing programs based on bandwidth requirements. To
complement its connectivity offerings, the Company also sells customer-premise
routers, firewall security options and other value-added services, as well as
assigns and manages IP and E-mail addresses.
Web Site Managment. The Company also offers a complete range of Web site
management solutions. The Company's Business Customers are able to locate Web
sites on dedicated servers at the Company's Web site management facility, which
enables users to gain high-speed access to the World Wide Web through the
server's direct connection to the Internet backbone. In addition, the Company
provides 24x7x365 monitoring of the server and Internet connection by the
Company's highly experienced technical staff, as well as easy server
upgradability to meet the customer's growing speed and capacity requirements.
In January 1997, the Company consummated the acquisition of Boston-based EPSG,
a prominent developer of electronic commerce applications and integration
services for high functionality, complex Web sites. The Company believes that
this acquisition builds on its strategy of providing complex Web site management
services to companies using their World Wide Web presence as a mission-critical
marketing, revenue generation and customer retention tool.
Private Network Solutions. The Company provides private label solutions to
telecommunications companies interested in offering Internet access to their
existing customer bases without incurring additional infrastructure costs.
The Company's Internet solutions are supported by a state-of-the-art network
infrastructure, including the Company's Network Operations Center (NOC) and Web
site management facility located in suburban Washington, D.C. The Company has
built a redundant nationwide DS-3 backbone connecting to six major Internet
network access points (NAPs) at 90 Mbps when fully operational and has
established peering relationships with other national Internet carriers,
allowing DIGEX to route its customers' traffic to the desired Internet address.
The Company believes that its combination of a nationwide network and peering
relationships significantly differentiates the Company from regional Internet
Service Providers ("ISPs") who, without peering relationships, may have to pay
transit fees to national Internet carriers in order to exchange network traffic.
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THE DIGEX STRATEGY
After receiving its first major infusion of institutional equity capital in
March 1995, the Company reoriented its strategy to focus on becoming the
Internet carrier of choice for Business Customers. DIGEX's strategy focuses on
six key elements:
Focus on Business Customers. The Company believes that Business Customers
offer the greatest potential market for the Company's solutions due to this
market's low customer turnover and need for higher value-added Internet
solutions. The Company continues to research and develop innovative, specialized
products and services that address the constantly evolving needs of Business
Customers at competitive prices. In addition, the Company believes that its
less-focused competition faces difficulty fulfilling the demanding needs of
these customers.
Provide Comprehensive Range of Internet Solutions. The Company provides a
comprehensive range of Internet solutions, enabling it to satisfy the needs of
Business Customers who often seek a sole provider for all their Internet
requirements. The Company's sales forces for each of its business units are
motivated to cross-market all of DIGEX's products and services.
Expand and Optimize Its Nationwide Network. The Company plans to expand its
nationwide DS-3 network, which the Company has designed to specifically address
the growing reliability and bandwidth requirements of Business Customers, so as
to offer a comprehensive range of connectivity solutions to such customers
across the United States. The Company believes that as it expands its network to
more cities, it can offer its solutions to additional Business Customers more
cost-effectively than its consumer-focused competitors, because fewer points of
presence ("POPs") are required to reach Business Customers, who are largely
concentrated in urban centers. In addition, the Company attempts to optimize its
network efficiency by counterbalancing business connectivity, which makes
greater use of the Company's network during business hours, with Web site
management, which makes greater use of the network during non-business hours.
Implement Multiple Distribution Channels. The Company aims to reach its
customers through the Company's own direct sales force as well as through other
innovative methods of distribution. These methods currently include agent
relationships with advertising agencies and Web site developers who resell the
Company's Web site management solutions and the efforts of the Company's Private
Network Group, which enters into long-term agreements with telecommunications
service providers to resell the Company's connectivity solutions under their own
brand names. In addition, Business Internet Connectivity uses agents and systems
integration firms as an indirect channel to supplement the direct channel sales
force for market coverage.
Establish Key Industry Partnerships. The Company has and continues to pursue
actively partnerships with industry leaders, including existing relationships
with Cisco Systems, Inc. ("Cisco"), Compaq Computer Corporation, Microsoft
Corporation ("Microsoft") and Raptor Systems, Inc. ("Raptor"). These
relationships assist the Company in vendor negotiations and with the generation
of qualified customer leads for distribution among the Company's three business
units, as well as position the Company as a provider of turnkey Internet
solutions.
Focus on Customer Acquisition and Retention. In addition to acquiring
customers through its existing distribution channels, the Company believes that
as consolidation of the industry continues and it becomes more difficult for
regional ISPs to compete, the Company will be able to acquire opportunistically
business-focused regional ISPs or purchase their subscriber bases. The Company
also believes that customer responsiveness is becoming a key ingredient of
success for ISPs and has formed three focused business units to better serve and
retain customers. To aid in this effort, the Company has developed a highly
trained direct sales force with extensive Internet expertise which, based on
customer feedback, the Company believes significantly differentiates the Company
from its competitors.
NETWORK INFRASTRUCTURE
DIGEX's current network infrastructure is based upon a DS-3 fiber optic ring
around the continental United States which provides two 45 Mbps paths between
the east and west coasts, allowing for a combined bandwidth of 90 Mbps when
fully operational. Customers can connect to the Company's network from major
cities across the United States. Clear channel DS-3 circuits in the ring connect
core routers in DIGEX POPs located in cities on the ring. In the event of a
single point of failure, traffic can be
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routed around the loop, providing for a minimum of 45 Mbps even in the event of
such a failure. Other network circuits connect routers in DIGEX POPs in cities
not located along the ring to nearby DIGEX routers residing on the ring. The
network backbone uses state-of-the-art routing platforms, including Cisco 7500
Series routers.
DIGEX customers are connected via high-speed leased lines, frame relay,
Switched Multimegabit Data Service (SMDS) or other technologies to the local
DIGEX POP, where data enters the DIGEX backbone. If the destination of the data
is on the DIGEX network, then the data is delivered without ever leaving DIGEX's
facilities. If the data is destined for an Internet customer connected via
another national ISP which has a peering relationship with DIGEX, then the data
is routed to the nearest peering location where the data is passed from the
DIGEX router to the router of the other ISP, who then carries that traffic to
the final destination. If the destination is an ISP which does not have a
peering relationship, then the data is delivered to the national Internet
carrier from whom such ISP purchases its Internet connectivity.
As of March 1997, DIGEX's comprehensive range of connectivity solutions are
available in 46 U.S. metropolitan areas through 43 POPs. The Company is also
deploying "virtual" POPs that allow the Company to cover metropolitan areas
without being required to build additional POPs. The Company expects to make its
connectivity solutions available in a total of 60 U.S. metropolitan areas
through 50 POPs by the end of 1997. In addition, the Company is acquiring OC-12
capacity to improve the network performance and customer service. DIGEX
currently leases the majority of its intercity backbone DS-3 circuits from MCI
Communications Corporation ("MCI") and Cable & Wireless, Inc. ("Cable &
Wireless"), as well as collocation space at their facilities for DIGEX housing
equipment. The Company is nearing the end of the first year of a five-year
agreement with MCI as well as having three- to five-year commitments from Cable
& Wireless for the lease of such circuits and the use of collocation space to
house DIGEX equipment. Management believes that it will be able to renew or
replace such contracts at comparable rates. Other DIGEX network segments and
customer connections are provided through local exchange carriers ("LECs") and
competitive access providers ("CAPs").
DIGEX's network is monitored on a 24x7x365 basis at its NOC. Trouble calls are
serviced by the technical staff of either the Business Internet Connectivity
Group, in the case of backbone or customer leased line difficulties, or the Web
Site Management Group, in the case of problems with customer servers. MCI and
Cable & Wireless provide installation and maintenance services to assist DIGEX
at all locations where the Company collocates equipment. For equipment at its
remote POPs, DIGEX purchases routers from Cisco, CSU/DSUs from Digital Link
Corporation, IDSUs and DSUs from Kentrox Industries Inc. and modems and ISDN
terminal adapters from Cisco. Protected AC or DC power is used at all sites to
protect against power outages affecting the network.
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In addition to these backbone facilities, DIGEX presently operates a Web site
management facility at its suburban Washington, D.C. headquarters and intends to
construct an additional Web site management facility and a back-up NOC on the
west coast by the end of 1997. The Company may decide to build additional Web
site management facilities in the future to better serve customer needs.
Multiple Web site management facilities allow Internet users to access the
server closest to major Internet nodes and thus provide a better level of
service, and would allow DIGEX to minimize the amount of server-related traffic
which it must carry long distances over its network.
PRODUCTS AND SERVICES
The Company offers Internet solutions through three separate and highly
focused business units.
Business Internet Connectivity Group
DIGEX provides complete connectivity solutions to its Business Customers,
including frame relay, leased lines and SMDS, with availability limited only by
the capabilities of the in-market LECs. The majority of the revenue generated by
Business Connectivity is derived from its frame relay, leased line and security
products. The Company offers several configurations and monthly pricing plans,
each based on the bandwidth supplied and thus on the speed and capacity of the
network facility. The retail pricing of Business Connectivity products ranges
from $395 per month to $35,775 per month, and customers are strongly encouraged
to enter into long-term contracts. The Company's products are highly scaleable
and are designed to facilitate ease of upgrade as the customer's needs evolve.
The following chart describes the Company's Business Connectivity options:
<TABLE>
<CAPTION>
SERVICE TYPE SUMMARY DESCRIPTION
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<S> <C>
Frame Relay Flat rate, scaleable 32 Kbps to 1.54 Mbps
technology for small to medium size business
applications.
Leased Line A complete range (56 Kbps to 45 Mbps) of
area/wide-area networks and enterprises running
all standard and high-bandwidth Internet
applications.
Ethernet Plus 2 Mbps to 16 Mbps connectivity solutions for easy
"plug and play" solution for Ethernet-based
networks running all Internet applications.
Switched Multimegabit Data A wide range of scaleable solutions (1.17 Mbps to
Service (SMDS) 34 Mbps) for Business Customers seeking a
cost-effective way to support all Internet
applications.
- --------------------------------------------------------------------------------
</TABLE>
In addition to basic connectivity service, DIGEX sells and configures
customer-premise routers, firewall security options and other value-added
services. DIGEX is an authorized reseller of the Eagle firewall product family
from Raptor, and FireWall-1 from Check Point Software Technologies Ltd. The
Company also offers Secure Computing Corporation's Sidewinder Internet firewall
software. In addition, the Company helps customers with initial use of their
particular DIGEX solution to become sophisticated Internet users. The Company
began providing Business Connectivity solutions in 1995 and plans to introduce
new products on a controlled basis, to ensure that the quality of delivery, from
both a sales and a support perspective, is in place and solidifies the Company's
reputation as a provider of highly reliable Internet solutions. The Business
Internet Connectivity Group generated 77% of the Company's total 1996 revenue.
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Web Site Management Group
The Company has offered a complete range of Web site management solutions
since 1994. The Company's Business Customers are able to locate highly reliable
Web sites on dedicated servers at the Company's Web site management facility,
which enables users to gain high speed access to the Web server given the
server's direct connection to the Internet backbone. In addition, the Company
provides 24x7x365 monitoring of the server and Internet connection by the
Company's highly experienced technical staff as well as easy server
upgradability as the customer's speed and capacity requirements grow. The
Company operates the largest dedicated server Web site management facility in
the world. In addition, it was the first carrier to offer its Web Site
Management customers a choice of UNIX or Windows NT 4.0 platforms. As Web server
needs evolve, DIGEX's goal is to continue to meet the market with the most
advanced server solutions available. DIGEX offers various Web server products
under the DIGEX WebPremier brand, of which the WebPremier NT and WebPremier UNIX
products account for the majority of the revenues generated by the Web Site
Management Group.
Within both the WebPremier NT and WebPremier UNIX product lines, the Company
offers a diversity of machine, software, network and service level configuration
options to meet the requirements of the corporate Web site customer.
Additionally, the Company offers its WebLocate product line which permits
companies to co-locate their own machine configuration at the DIGEX network
facility. For WebLocate customers, DIGEX provides security, network
connectivity, uninterrupted power supply and 24x7x365 monitoring to ensure the
machine configuration is connected to the Internet.
The Web Site Management Group generated 18% of the Company's total 1996
revenue.
Private Network Group
The Private Network Group creates customized solutions for telecommunications
service providers looking to offer highly reliable private label Internet
connectivity solutions without incurring the lead time and costs associated with
building their own facilities. In turn, these providers absorb customer-
acquisition costs that would otherwise be borne by the Company. When an
individual contract is secured, a customized implementation and service
organization is created to provide a premium level of support for the private
network customer. The Company expects that the operations of the private network
customer and the DIGEX support team will be integrated to enhance customer
support.
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The Company began offering private network solutions in 1996 and entered into
multi-year private network agreements with LCI International, Inc. ("LCI"),
WinStar Communications, Inc. ("Winstar") and Orion Network Systems ("Orion"),
among others. The Private Network Group seeks to enter into multi-year
agreements having either take-or-pay commitments or bulk discounts based on the
aggregate amount of Internet solutions purchased. The Company's private network
agreement with LCI provides for a large-scale, multi-year commitment by LCI to
purchase Internet products and services from DIGEX. Similarly, the Company's
private network agreement with WinStar, which terminates in June 2002, requires
WinStar to purchase a minimum of $5.0 million of Internet connectivity solutions
with the right to purchase additional amounts, in each case on a discounted
basis. DIGEX's agreement with Orion provides for bulk discounts through July
1999, based on the aggregate amount of Internet services purchased. The Private
Networks Group generated 5% of the Company's total 1996 revenue.
CUSTOMERS
The Company's Business Connectivity and Web Site Management customers have
expanded from approximately 500 at December 31, 1995 to approximately 1,505
accounts at December 31, 1996. In addition, at December 31, 1996, the Company
had contracts for approximately 350 additional accounts, service on which had
not yet begun. In 1995 and 1996, no customer accounted for more than five
percent of the Company's total revenues.
SALES AND MARKETING
As of December 31, 1996, the Company employed 153 people in sales and
marketing. To date, the Company has sold its Internet solutions primarily
through its direct sales force. Sales activity is generated both by outbound
relationship building and in response to customer referrals, E-mail
correspondence through the Company's Web site and a variety of promotional
programs, including advertising in general business and specialty periodicals,
participation in industry trade shows, seminars and press relations. In
addition, the Company engages in local promotional programs to support newly
opened service locations. In order to better serve the needs of its customers,
the Company has developed a specialized marketing approach for each business
unit. Furthermore, the Company is beginning to increase its national presence
through high profile television and print advertisements.
The sales force for the Company's Business Internet Connectivity Group
continues to grow to meet the demands of customers along DIGEX's expanding
nationwide network. The Company has added sales representatives who are focused
on the cities where the Company has opened new POPs along the network and
supports them with marketing programs to generate qualified sales leads. In
addition, the Company plans to purchase prequalified sales leads, to solicit
customers through direct mail advertising, to conduct sales seminars, to
advertise in national trade publications and to participate in industry trade
shows. An Indirect Sales Agent Program was launched by the Company with systems
integrators and VARS to sell Business Internet Connectivity. The Company
believes that active marketing and lead generation efforts will allow the sales
force to become even more productive and efficient.
In addition to using the Business Internet Connectivity Group's sales force
for marketing its products and services, the Web site Management Group has
implemented a direct field sales organization, which currently operates in 16
major markets throughout the U.S. This sales organization calls on corporations
within their assigned geographic territory to offer DIGEX Web site Management
Services. In addition to directly calling on corporations, the field sales
organization engages and supports DIGEX Alliance Partners. Alliance Partners
are select advertising agencies, graphic design firms and Web development
companies whose business includes the creation of Web sites for corporate
customers. Currently, DIGEX has agreements with over 90 Alliance Partners. The
field sales organization supports these Alliance Partners to cause them to refer
Web site management assignments to DIGEX in exchange for a referral commission.
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The Private Network Group has a dedicated business development team which
targets a number of types of potential customers, including Interexchange
carriers ("IXCs"), LECs, cable operators, large private network providers, and
CAPs. The Company seeks to enter into long-term, non-exclusive arrangements with
these potential resellers.
COMPETITION
The market for all types of Internet connectivity services is extremely
competitive. There are no substantial barriers to entry, and the Company expects
that competition will intensify in the future. As a result of an increase in the
number of competitors, and vertical and horizontal integration in the industry,
the Company expects to encounter significant pricing pressure and other
competition in the future. Advances in technology as well as changes in the
marketplace and the regulatory environment are constantly occurring, and the
Company cannot predict the effect that ongoing or future developments may have
on the Internet industry generally or on the Company specifically.
National Internet Carriers. Currently, the Company's primary competitors are
other Internet carriers focused on Business Customers, including UUNET
Technologies, Inc. ("UUNET"), BBN Planets Corporation ("BBN") and PSINet, Inc.
("PSINet"). UUNET, BBN and PSINet in particular have significantly greater
market presence and financial, technological and personnel resources than the
Company and have extensive coast-to-coast Internet backbones.
A number of these competitors, however, including UUNET and PSINet, have
chosen to pursue individual connectivity customers in an effort to balance the
use of their networks. As a result, these Internet carriers have been forced to
build out their networks beyond what would be necessary to serve Business
Customers.
DIGEX, on the other hand, has found that it can maintain its focus on Business
Customers and build a network infrastructure that can serve a substantial
majority of the business marketplace with significantly fewer POPs than its
competitors. In addition, the Company's Web site management business, while
offering additional Internet solutions to its Business Customers, generates a
substantial portion of its traffic after business hours, and thus balances the
usage of the Company's network. Thus, given its more focused business strategy
and more efficient use of network capacity, DIGEX can offer a comprehensive
range of business Internet solutions on a cost-effective basis.
To a lesser extent, the Company competes with other national Internet carriers
and regional ISPs, of which there are currently over 4,000. Many of these
competitors, however, including Earthlink Network ("Earthlink"), do not share
DIGEX's business focus. In addition, due to the substantial increase in the
amount of data traffic carried by the networks of certain national Internet
carriers, the Company expects the industry's current practice regarding peering
to evolve by the end of 1997 to require an Internet carrier to have (i) a coast-
to-coast DS-3 backbone, (ii) 45 Mbps connections to a minimum of six U.S.
peering points and private peering relationships and (iii) a 24x7x365 NOC in
order to qualify for peering with the major national Internet carriers. The
Company expects Internet carriers or ISPs which do not satisfy these
requirements by the end of 1997 either to be acquired by the large national
Internet carriers or to be forced to become resellers of Internet connectivity
services, purchasing their network bandwidth at retail rates from national
Internet carriers.
Telecommunications Companies. The Company currently competes with AT&T
Worldnet Services ("AT&T"), MCI and Sprint Corporation's IP Services ("Sprint").
In addition, a number of regulatory obstacles to the entry of other
telecommunications companies into the Internet connectivity market are being
removed. Accordingly, the Company expects competition to increase with other
major telecommunications companies, including WorldCom Inc. ("WorldCom") and the
Regional Bell Operating Companies ("RBOCs"). In addition, deregulation of the
telecommunications industry has already led to significant horizontal
integration through acquisitions and joint ventures, and the Company expects
these trends to continue.
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The Company competes with telecommunications companies which have access to
significantly greater financial, technological and personnel resources than the
Company and large existing commercial customer bases. In addition, IXCs,
including AT&T, MCI and Sprint, possess existing nationwide telecommunications
networks and generally face lower network infrastructure costs in providing
Internet connectivity than the Company. Although its WorldNet offering targets
the consumer market, AT&T is party to an agreement with BBN pursuant to which it
can market BBN's business connectivity services to AT&T's commercial customer
base or, in the alternative, provide its own Internet connectivity. While these
telecommunications companies have little experience with Transmission Control
Protocol/Internet Protocol ("TCP/IP") networking in general, and Internet
connectivity in particular, they now may employ their larger sales organizations
to sell Internet connectivity to their existing telephony customers, both
commercial and consumer. However, the Company believes that its sales and
marketing personnel, which have backgrounds in data-oriented services,
particularly TCP/IP will be able to sell Internet connectivity more effectively
than the sales forces of most telecommunications companies, which possess
backgrounds largely in voice-oriented services.
LECs, such as the RBOCs, and CAPs on the other hand, do not currently possess
nationwide networks. In order to address the Internet connectivity requirements
of their current business customer bases, these companies must either buy
connectivity to an Internet network infrastructure or build such a network. For
example, MFS Communications Company (now a part of WorldCom) acquired UUNET to
offer expanded Internet connectivity along with its traditional
telecommunications services. The Company seeks to capitalize on the market
opportunity created by telecommunications companies that have chosen to buy, not
build, Internet connectivity for resale through its Private Network Group, which
sells DIGEX's Internet connectivity services to telecommunications companies to
be remarketed under their own brands.
Cable Television and Direct Broadcast Satellite. Certain companies are
exploring the possibility of providing high-speed data services using
alternative delivery methods. For example, @Home, a joint venture between Tele-
Communications, Inc. and Kleiner Perkins Caufield & Byers, has stated its intent
to provide high-speed data services over cable television facilities, and Hughes
Network Systems ("HNS") has launched DirectPC, which will deliver high-speed
data through direct broadcast satellite technology. CAI Wireless Systems, Inc.,
a wireless cable television service, also has announced that it has begun
testing the first Internet connectivity product delivered by wireless cable.
However, since they do not currently possess nationwide networks, these
companies, in order to provide Internet access, must either buy access to an
Internet network infrastructure or build such a network.
On-Line Service Providers. The Company also competes, to a lesser extent, with
certain on-line service providers who offer Internet connectivity in conjunction
with their primary products or services. For example, Microsoft provides
connectivity to the Internet through the Microsoft Network, which was built by
UUNET, as a standard integrated feature of its Windows 95 operating system, and
IBM's OS/2 WARP operating system is preconfigured to provide Internet
connectivity through the Advantis network, which is controlled by IBM. In
addition, America Online, Inc. ("AOL"), CompuServe, Inc. ("CompuServe") and
Prodigy Services Company ("Prodigy") currently provide connectivity to the
Internet, and many have announced plans to offer expanded Internet connectivity
capabilities. Currently, on-line service providers are primarily focused on the
consumer marketplace.
Web Site Management Competition. The market for Web site management is highly
fragmented and extremely competitive. There are no substantial barriers to entry
and the Company expects the competition will intensify in the future. Currently,
the Company's primary competitors are other Internet carriers, including BBN,
UUNET and MCI. In addition, many organizations currently host Web servers at
their own facilities. The Company believes, however, that as bandwidth
requirements increase, it will become more economical for these organizations to
outsource their needs. The Company believes that it significantly differentiates
itself from its competitors by offering flat-rate billing, dedicated servers,
24x7x365 monitoring, upgradability and other value-added services demanded by
high-end Business Customers.
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INVESTMENT CONSIDERATIONS
The following factors, in addition to the other information contained
elsewhere herein, should be considered carefully in evaluating the Company and
its business.
History of Losses
At December 31, 1996, the Company had an accumulated deficit of approximately
$28.4 million. The Company incurred a net loss of $23.3 million for the year
ended December 31, 1996. The Company continues to make significant capital
expenditures intended to expand the Company's network and organizational
infrastructure, and expects to incur operating and net losses in 1997. In
addition, the Company expects to focus in the near term on increasing its
subscriber base of high-end Web Site Management and Business Connectivity
customers, which will require it to increase and accelerate its overall sales
and marketing costs in 1997, and which, accordingly, is likely to have an
adverse affect on operating results, at least in the near term. There can be no
assurance that the Company will achieve or sustain profitability in the future.
Difficulties in Managing Growth
The rapid growth of the Company's business and its product and service
offerings have placed, and is expected to continue to place, a significant
strain on the Company's managerial, operational and accounting resources.
Demands on the Company's operational and accounting information systems and
controls, including its billing, accounts receivable and payable tracking and
other accounting systems, grew rapidly during 1996 with the Company's expanding
customer and employee bases corresponding with its new focus on Business
Customers. In 1995, the Company experienced difficulties in billing its
customers, pursuing delinquent accounts receivable balances, recording payables
in the proper period, performing timely reconciliations of financial statement
data on a monthly basis and maintaining adequate accounting controls. The
Company took actions to upgrade and improve its accounting systems and controls
and to increase the number of qualified accounting personnel during 1996.
Increasing demands for the Company's Internet solutions and related customer
support services have also created additional demands on the Company's network
infrastructure and technical support and customer service personnel. The Company
has in the past experienced difficulties making installations on a timely basis
and providing adequate customer support. Although the Company has hired
additional support and customer service personnel and has established a 24x7x365
NOC, it is possible that such difficulties will continue in the future. In
addition, the Company must integrate approximately 40 employees added in
connection with its acquisition of EPSG in January 1997.
The Company has a new management team and a substantial number of new
employees. As of December 31, 1995, the Company had 106 employees, and at
December 31, 1996, the Company had 314 employees. In addition, key members of
the Company's current management team, including Christopher R. McCleary, the
Company's Chairman, President and Chief Executive Officer; Brian M. Deobald, the
Company's Vice President, Business Development; Earl P. Galleher, the Company's
President, Web Site Management Group; Nicholas J. Magliato, the Company's Vice
President, Private Networks Group; and John C. Welling, the Company's Vice
President, Chief Financial Officer and Controller have joined the Company since
February 1996.
To manage its growth, the Company must continue to improve its operational and
accounting information systems and controls and must continue to attract and
retain additional highly qualified management, financial, technical, sales and
marketing and customer service personnel. Any failure of the Company to manage
its growth effectively could have a material adverse effect on the Company's
business, financial condition and results of operations.
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Future Capital Needs and Current Financing Arrangements
The Company currently anticipates that the remaining proceeds of the Company's
1996 initial public offering, together with approximately $19 million of secured
lease financing and other financing arrangements and funds from operations, will
be sufficient to meet the Company's anticipated working capital, lease
commitments, network expansion and capital expenditure requirements in 1997.
However, the Company anticipates that it will seek to arrange additional public
or private debt or equity financing, including, potentially, additional
equipment financing, to afford the Company greater liquidity and flexibility.
There can be no assurance that the Company will be able to arrange such
additional financing on acceptable terms or at all. Moreover, the Company may
need to raise additional funds in the event that the Company's estimates of
operating losses and capital requirements change or prove inaccurate or in order
for the Company to respond to unanticipated competitive pressures or to take
advantage of unanticipated opportunities. Such opportunities could include the
acquisition of business-focused regional ISPs or the purchase of their
subscriber bases, international expansion, acquisitions of complementary
businesses or technologies and the development of new products. There can be no
assurance that additional financing will be available on terms favorable to the
Company, or at all. If adequate funds are not available or are not available on
acceptable terms, the Company may not be able to continue its network expansion,
to take advantage of market opportunities, to develop new products or otherwise
to respond to competitive pressures. Such inability could have a material
adverse effect on the Company's business, financial condition and results of
operations.
In addition, the Company's financing arrangements are secured by many of the
Company's assets. Such collateral security arrangements entitle the Company's
secured lenders to foreclose upon some of the Company's assets in the event of a
default under the Company's financing arrangements and may adversely affect the
Company's ability to obtain additional financing.
Dependence on Network Infrastructure, Maintenance of Peering Relationships
The Company's success will depend upon the geographic reach, capacity,
reliability and security of its network infrastructure. The Internet is
comprised of many Internet carriers who operate their own networks and
interconnect with other Internet carriers at various peering points. The
establishment and maintenance of peering relationships with other Internet
carriers is necessary in order to exchange traffic with other Internet carriers
without having to pay retail rates. The Company expects the industry's current
practice regarding peering to evolve by the end of 1997 to require an Internet
carrier to have (i) a coast-to-coast DS-3 backbone, (ii) 45 Mbps connections to
a minimum of six U.S. peering points and private peering relationships and
(iii) a 24x7x365 NOC in order to qualify for peering with the major national
Internet carriers. Although the Company currently meets these requirements,
there is no assurance that other national Internet carriers will maintain
peering relationships with the Company. In addition, there may develop
increasing requirements associated with maintaining peering with the major
national Internet carriers with which the Company may have to comply. The
Company also expects to be required to expand and adapt its network
infrastructure in order to respond to its growing number of customers, demands
to transmit increasing amounts of data and changes to its customers' product and
service requirements. The expansion and adaptation of the Company's network
infrastructure will require substantial financial, operational and managerial
resources. There can be no assurance that the Company will be able to expand or
adapt its network infrastructure to meet the industry's evolving standards or
its customers' growing demand and changing requirements on a timely basis, at a
commercially reasonable cost, or at all, or that the Company will be able to
deploy successfully any expanded and adapted network infrastructure.
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Risks to Physical Network and Integrity of Data on Network
The Company's operations are dependent upon its ability to protect its network
infrastructure against damage from fire, earthquakes, severe flooding,
mudslides, power loss, telecommunications failures and similar events or to
construct networks which are not vulnerable to the effects of these events. A
significant portion of the Company's computer equipment, including components
critical to the operation of its Internet backbone, is located at the Company's
facilities in Beltsville, Maryland. The Company experienced a four-hour service
interruption due to severe flooding in Pennsylvania in 1996. The Company
believes that this type of service interruption is not abnormal in the industry.
However the occurrence of a natural disaster or other unanticipated problems at
the Company's NOC, its hubs (sites at which the Company has located routers,
switches and other computer equipment which make up the backbone of the
Company's network infrastructure) or at a number of the Company's POPs in the
future could cause additional major interruptions in the services provided by
the Company. Furthermore, the failure of an individual POP would result in
interruption of service to the customers served by such POP until necessary
repairs were effected or replacement equipment was installed.
In addition, some Internet carriers have in the past experienced interruptions
in service as a result of the accidental or intentional actions of Internet
users, current and former employees or others, and the Company has experienced
interruptions in service as a result of accidental or intentional actions of
Internet users. Further interruptions of service may occur in the future. In the
past, there have been break-ins to computers connected to the Internet at
General Electric Company, Sprint and IBM, as well as the computer systems of
NETCOM and the San Diego Supercomputer Center, and there have also been
incidents involving hackers bypassing firewalls and stealing sensitive
information. Unauthorized use of the Company's network could jeopardize the
security of confidential information stored in the computer systems of the
Company and its customers, which may result in liability of the Company to its
customers or deter potential subscribers. The industry-standard network security
measures in use by the Company have been circumvented at other companies'
facilities and educational facilities in the past but not at the Company's
facilities. However, there can be no assurance that such measures will not be
circumvented in the future at the Company.
The failure of the Company to adequately manage service disruptions resulting
from physical damage to its network or breaches of the network's integrity,
could have a material adverse effect on the Company's business, financial
condition and results of operations.
Dependence Upon Suppliers and Limited Sources of Supply
The Company relies on other companies to supply certain key components of its
network infrastructure, including telecommunications services and networking
equipment which, in the quantities and quality demanded by the Company, are
available only from limited sources. For example, the Company currently relies
on Cisco to supply routers critical to the Company's network, and the Company
could be adversely affected if routers from Cisco were to become unavailable on
commercially reasonable terms. MCI, which is a competitor of the Company, and
Cable & Wireless are the Company's primary providers of data communications
facilities and network capacity and lease physical space to the Company for
routers, modems and other equipment. The Company is also dependent upon LECs and
CAPs to provide telecommunications services to the Company and its customers.
The Company expects these telecommunications companies to become competitors of
the Company as well. The Company has from time to time experienced delays in
receiving telecommunications services, and there can be no assurance that the
Company will be able to obtain such services on the scale and within the time
frames required by the Company at a commercially reasonable cost, or at all.
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Certain of the Company's suppliers, including the RBOCs and certain other
LECs, are currently subject to tariff controls and other price constraints which
in the future could be changed. In addition, regulations under the
Telecommunications Act of 1996 will affect the prices charged to the Company by
the RBOCs and certain other LECs. Such regulatory changes, including the
possible imposition of access charges upon Internet carriers or ISPs, could
result in increased prices of services and products to the Company.
Dependence Upon Key Personnel
The Company's success will depend upon the continued service of its senior
management team and its technical, marketing and sales personnel. The Company's
employees, including members of its management team, may voluntarily terminate
their employment with the Company at any time, and competition for qualified
employees in the Internet industry is intense. Six senior executives do,
however, have employment agreements with the Company which expire at various
times in 1997 (or, in the case of Christopher McCleary, the Company's Chairman,
President and Chief Executive Officer, in December 1999). Although most of
these employment agreements contain non-competition and non-disclosure
agreements, there can be no assurance that these provisions will be enforceable
in whole or in part. Except for key-person insurance the Company maintains on
Douglas E. Humphrey, its Senior Vice President, Chief Technology Officer and co-
founder, the Company does not maintain key-person insurance on any executive
officer of the Company. The loss of the services of key personnel could have a
material adverse effect upon the Company's business, financial condition, and
results of operations.
Dependence Upon Continued Development of Business Market
A substantial portion of the Company's revenues to date have been, and
substantially all of the Company's revenues for the foreseeable future will be,
derived from the sale of its Internet solutions to Business Customers. The
Company's success will depend upon the continued development and expansion of
the business market for Internet solutions and the networks which comprise the
Internet, as well as the extent to which Internet connectivity becomes critical
to achievement of the objectives of the Company's Business Customers. Certain
key issues concerning the extensive use of the Internet by Business Customers,
including data security, network reliability, ease and cost of access and
quality of service remain unresolved and may impact the growth of Internet use
by Business Customers. In particular, numerous published reports have indicated
that a perceived lack of security of commercial data, such as credit card
numbers, has significantly impeded commercial exploitation of the Internet to
date, and there can be no assurance that encryption or other technologies will
be developed that satisfactorily addresses these security concerns. Published
reports have also indicated that capacity constraints caused by growth in the
use of the Internet may, unless resolved, impede further development of the
Internet to the extent that users experience delays, transmission errors and
other difficulties. The failure of the market for business-related Internet
solutions to continue to develop would adversely impact the Company's business,
financial condition and results of operations.
Dependence Upon Product Development and Risks of Changing Technology and
Industry Standards
The Company's success will depend upon its ability to respond to the rapidly
changing requirements of its Business Customers for Internet solutions. The
Internet industry is characterized by rapidly changing technology and evolving
industry standards, emerging competition and frequent new product and service
introductions. There can be no assurance that the Company can successfully
identify new product opportunities or develop and bring new products and
services to market in a timely manner. In order to continue to remain
competitive, the Company must be able to continue to foresee industry trends and
to adapt and modify its business strategies accordingly. The Company is also
at risk from fundamental technological changes in the way Internet solutions are
marketed and delivered. Integrating technological advances may require
substantial time and expense, and there can be no assurance that the Company
will succeed in adapting its network infrastructure.
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In addition, new technologies or industry standards have the potential to
replace or provide lower cost alternatives to the Company's existing products
and services. The adoption of such new technologies or industry standards could
render the Company's existing products and services obsolete and unmarketable.
For example, the Company's services rely on the continued widespread commercial
use of TCP/IP. Alternative open and proprietary protocol standards that compete
with TCP/IP, including proprietary protocols developed by IBM and Novell, Inc.,
have been or are being developed.
Failure of the Company to adapt to changes in technology and industry
standards would have a material adverse effect on the Company's business,
financial condition and results of operations.
Potential Liability for Information Disseminated Over Network
The law relating to the liability of on-line service providers and ISPs for
information carried on or disseminated through the facilities of their networks
is currently unsettled. Several lawsuits seeking a judgment of such liability
are currently pending. In one case brought against an ISP, Religious Technology
Center v. Netcom On-Line Communication Services, Inc., the United States
District Court for the Northern District of California ruled in a preliminary
phase that under certain circumstances ISPs could be held liable for copyright
infringement. The case has not reached final judgment. No such case has been
brought against the Company, although the Company has recently received notice
of allegations that content carried on third-party Web pages hosted by the
Company may infringe on other persons' copyrights. The Telecommunications Act of
1996 prohibits and imposes criminal penalties and civil liability for using an
interactive computer service for transmitting certain types of information and
content, such as indecent or obscene communications. This provision has been
declared unconstitutional by the United States District Court for the Eastern
District of Pennsylvania. The decision has been appealed to the United States
Supreme Court, which recently heard oral arguments in the case and is reviewing
the decision. Numerous states have adopted or are currently considering similar
types of legislation. The imposition upon Internet carriers or Web server hosts
of potential liability for materials carried on or disseminated through their
systems could require the Company to implement measures to reduce its exposure
to such liability, which may require the expenditure of substantial resources or
the discontinuation of certain product or service offerings. The Company
believes that it is currently unsettled whether the Telecommunications Act of
1996 prohibits and imposes liability for any services provided by the Company
should the content of information transmitted be subject to the statute.
Although the Company is not currently subject to direct regulation by the
Federal Communications Commission (the ''FCC'') or any other federal or state
agency, changes in the regulatory environment relating to the Internet
connectivity market, including regulatory changes which directly or indirectly
affect telecommunications costs or increase the likelihood or scope of
competition from the RBOCs or other telecommunications companies, could affect
the prices at which the Company may sell its services. For example, proposed
regulations at the FCC would require discounted Internet connectivity rates for
schools and libraries. In addition, the FCC has issued a general "notice of
inquiry" regarding its regulation over Internet matters and is currently
considering responses to such inquiry. Finally, certain localities have imposed
a tax on companies that connect customers to the Internet, and other localities
may impose similar taxes. The Company cannot predict the impact, if any, that
future regulation or regulatory changes may have on its business.
Volatility of Stock Price
The stock market has from time to time experienced significant price and
volume fluctuations which have particularly affected the market prices of the
stocks of Internet carriers and other technology companies and may be unrelated
to the operating performance of particular companies. Factors such as quarterly
variations in actual or anticipated operating results, changes in earnings
estimated by analysts, market conditions in the industry, announcements by
competitors, regulatory actions and general economic conditions may have a
significant effect on the market price of the Common Stock.
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EMPLOYEES
As of December 31, 1996, the Company employed 314 persons full-time, including
143 in sales and marketing, 117 in network operations and 54 in general and
administrative functions. In addition, in 1997 the Company added approximately
40 employees as a result of the acquisition of EPSG. None of the Company's
employees is represented by a labor union, and the Company considers its
employee relations to be good.
ITEM 2. DESCRIPTION OF PROPERTY
The Company's administrative offices, as well as its NOC and Web Site
management facility, are located in Beltsville, Maryland, where the Company
currently leases approximately 90,000 square feet under leases that expire in
1998 and 2000. The Company believes that this facility will meet its needs
through at least the remainder of 1997. In addition, the Company leases
approximately 8200 square feet in Boston, Massachusetts as its center for EPSG.
The Company intends to lease space on the west coast of the United States to
house a back-up NOC and a second Web Site management facility, which the
Company expects to construct in 1997. The Company also leases space (typically
less than 200 square feet) in various geographic locations to house the
telecommunications equipment for each of its POPs. See ``Network
Infrastructure'' in Item 1 for a description of the components of the Company's
nationwide network, the Company's NOC and the current Web Site management
facility.
ITEM 3. LEGAL PROCEEDINGS
From time to time, the Company has been threatened with or named as a
defendent in lawsuits. Certain of such threatened litigation relate to novel or
unresolved issues arising out of or relating to the developing nature of the
Internet. See "Investment Considerations Potential Liability for Information
Disseminated Over Network" in Item 1. The Company is not involved in any legal
matters which the Company believes would, if adversely determined, have a
material effect upon its business or results of operations. There can be no
assurance whether these matters will be determined in a manner which is
favorable to the Company or, if adversely determined, whether such determination
would have a material adverse effect upon the Company's business, financial
condition or results of operations.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Since the Company's initial public offering of Common Stock in October 1996,
no matters have been submitted to a vote of security holders. From the beginning
of the fourth quarter on October 1, 1996 through the initial public offering,
certain matters were approved by unanimous written consent of the Company's
stockholders. By unanimous written consent of October 4, 1996, the Company's
stockholders approved a 2.5:1 reverse stock split and a merger of the Company
(then a Maryland corporation) into its wholly-owned subsidiary, a Delaware
corporation. The stockholders also approved the Company's employee benefit
plans. By unanimous written consent of October 15, 1996, certain amendments of
the Delaware subsidiary's certificate of incorporation were approved: (I)
provision of staggered board terms for directors, (II) removal of the ability of
the stockholders to call a stockholder meeting, and (III) requiring advance
notice of actions to be proposed at any stockholder meeting.
PART II
ITEM 5. MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
SALES OF UNREGISTERED SECURITIES
The Company made certain sales of unregistered securities in 1996 prior to its
initial public offering of Common Stock in October 1996. On February 21, 1996,
the Company issued 10% promissory notes due June 1, 1996 in the principal amount
of $1,000,000 (The "February 1996 Notes") and additional warrants to purchase
166,378 shares of Common Stock to Grotech Capital Partners IV, L.P. ("Grotech
IV"), Venrock Associates ("Venrock"), Venrock Associates II L.P. ("Venrock II"),
and Southern Venture Fund II, L.P. ("Southern") (together, the "Investors") as
follows: Grotech IV purchased promissory notes in the principal amount of
$400,000 and warrants to purchase 66,551 shares of Common Stock for a cash
purchase price of $400,000; Venrock purchased promissory notes in the principal
amount of $217,000 and
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warrants to purchase 36,104 shares of Common Stock for a cash purchase price of
$217,000; Venrock II purchased promissory notes in the principal amount of
$133,000 and warrants to purchase 22,128 shares of Common Stock for a cash
purchase price at $133,000; and Southern purchased promissory notes in the
principal amount of $250,000 and warrants to purchase 41,595 shares of Common
Stock for a cash purchase price of $250,000.
On May 21, 1996, the Company issued additional promissory notes in the
principal amount of $1,000,000 (the "Convertible Notes") convertible into shares
of Series B Preferred Stock of the Company to the Investors as follows: Grotech
IV purchased promissory notes in the principal amount of $400,000 for a cash
purchase price of $400,000; Venrock purchased promissory notes in the principal
amount of $217,000 for a cash purchase price of $217,000; Venrock II purchased
promissory notes in the principal amount of $133,000 for a cash purchase price
of $133,000; and Southern purchased promissory notes in the principal amount of
$250,000 for a cash purchase price of $250,000.
On May 30, 1996, the Company, the Company's founders (Mssrs. Douglas E.
Humphrey and Michael T. Doughney), the Investors, Grotech Partners III, L.P.
("Grotech Partners"), Grotech III Companion Fund, L.P. ("Grotech Companion"),
Grotech III Pennsylvania Fund, L.P. ("Grotech Pennsylvania"), Blue Chip Capital
Fund Limited Partnership ("Blue Chip") and Crisler Capital Company, Limited
Partnership (together with the Investors, Grotech Partners, Grotech Companion,
Grotech Pennsylvania and Blue Chip, the "Purchasers") entered into the Purchase
and Exchange Agreement, whereby the Investors exchanged $2.0 million principal
amount of certain notes issued in November 1995 and $1.0 million principal
amount February 1996 Notes (together with the right to receive $126,389 in
accrued interest thereon from the date of issuance) for 31,263.89 shares of
Series B Convertible Preferred Stock of the Company, par value $1.00 per share
(the "Series B Preferred Stock"), and converted $1.0 million principal amount of
Convertible Notes, in accordance with their terms, into 10,000 shares of Series
B Preferred Stock. In addition, the Purchasers paid $4,000,000 in cash in
exchange for a further 40,000 shares of Series B Preferred Stock. The above-
referenced exchange, conversion, and purchase resulted in the following
acquisitions of Series B Preferred Stock: Grotech IV acquired 22,505.26 shares
of Series B Preferred Stock; Grotech Partners acquired 8,537 shares of Series B
preferred Stock; Grotech Companion acquired 930 shares of Series B Preferred
Stock; Grotech Pennsylvania acquired 533 shares of Series B Preferred Stock;
Venrock acquired 10,914.77 shares of Series B Preferred Stock; Venrock II
acquired 5,860.92 shares of Series B Preferred Stock. Southern acquired
11,982.64 shares of Series B Preferred Stock; Blue Chip acquired 16,000 shares
of Series B Preferred Stock; and Crisler acquired 4,000 shares of Series B
Preferred Stock.
In June 1996, the Company entered into a multi-year private network agreement
with WinStar. As part of the agreement, WinStar advanced $5,000,000 to the
Company for connectivity services and received warrants to purchase 240,000
shares of Common Stock.
The holders of all outstanding shares of the Company's preferred stock
converted their outstanding shares of preferred stock into shares of Common
Stock in connection with the Company's initial public offering of Common Stock.
In addition, all holders of warrants to purchase Common Stock (other than
WinStar) exercised such warrants to purchase shares of Common Stock in
connection with the Company's initial public offering of Common Stock.
No underwriters were involved in any of the foregoing transactions. The sales
of all such securities were deemed to be exempt from registration under the Act,
in reliance on Section 4(2) thereunder, as transactions by an issuer not
involving any public offering.
In addition, at various times in 1996 prior to the Company's initial public
offering, the Company granted options to purchase shares of Common Stock of the
Company to certain Company employees. These grants were exempt from registration
pursuant to Section 4(2) of the Act of Rule 701 thereunder or other applicable
exemptions.
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COMMON STOCK PRICES
The Company Common Stock is listed under the symbol "DIGX" on the Nasdaq
National Market System ("NASDAQ"). The following sets forth the high and low
closing prices on the NASDAQ of the Common Stock since the Company completed its
initial public offering of its Common Stock in October 1996. Prior to its
initial public offering of Common Stock, there was no established trading market
for the Common Stock.
1996 High Low
---- ---
Fourth quarter (from October 17, 1996) $12.75 $10.00
COMMON STOCKHOLDERS
As of March 26, 1997, there were approximately 63 holders of record of the
Company's Common Stock.
DIVIDENDS
The Company has not paid a dividend on its common stock and no cash dividends
are expected to be paid for the foreseeable future.
ITEM 6. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
OVERVIEW
DIGEX is a leading national Internet carrier that focuses exclusively on
Business Customers. After receiving its first major infusion of institutional
equity capital in March 1995, the Company reoriented its strategy to focus
exclusively on Business Customers, who generally require high bandwidth
connectivity, and also began to develop its Web Site management business. The
Company brought in an experienced management team in the first quarter of 1996.
In the second quarter of 1996, the Company completed a DS-3 backbone ring around
the continental United States, enabling the Company to provide its solutions to
Business Customers nationwide.
The Company derives its revenue from providing a comprehensive range of
INDUSTRIAL STRENGTH Internet solutions, including Business connectivity, Web
Site management and security and other network products. Business Connectivity
and Web site management customers are typically signed to contracts with
minimum terms of one year. Revenues generated from these customers are
typically in the form of recurring monthly fees, installation and start-up
charges and sales of related equipment, applications and services.
The Company has made significant investments in developing and expanding its
network infrastructure and its customer service and sales and marketing efforts.
The substantial costs incurred in connection with this expansion contributed
heavily to the Company's operating losses in 1995 and 1996. In anticipation of
future growth, the Company expects to continue to make significant investments
in its network infrastructure, to be funded primarily from existing cash and
equipment financing. In addition, the Company expects to focus in the near term
on increasing its subscriber base of high-end Web Site Management and Business
Connectivity customers, which will require it to increase and accelerate its
overall sales and marketing costs, as higher sales and marketing costs are
incurred in the first half of 1997 in order to capture high-end customers more
quickly. This effort is likely to have an adverse effect on operating results,
at least in the near term. The Company's Business Connectivity and Web Site
Management customers have expanded from approximately 500 accounts at December
31, 1995 to approximately 1,505 accounts at December 31, 1996. In addition, at
December 31, 1996, the Company had contracts for approximately 350 additional
accounts, service on which had not yet begun.
The Company's operating results have fluctuated and will continue to fluctuate
from period to period depending upon factors such as the timing and installation
of significant orders, the pricing and mix of services and products sold by the
Company, terminations of service, new product introductions by the
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Company and its competitors, market acceptance of new and enhanced versions of
the Company's products and services, changes in pricing policies by its
competitors, the Company's ability to obtain sufficient supplies of limited
source components, the lengthening of the Company's sales cycle and the timing
of the expansion of the Company's network infrastructure.
In view of the significant growth of the Company's operations, the Company
believes that period-to-period comparisons of its financial results should not
be relied upon as an indication of future performance and that the Company may
experience future period-to-period fluctuation in operating results. The
Company's short-term focus is on building and expanding its customer base, which
will require it to make significant investments in its network infrastructure,
personnel, marketing, the development of new products and services, and, in
particular, sales and marketing costs, which may adversely impact short-term
operating results. The Company expects to incur operating and net losses in
1997. There can be no assurance that the Company will achieve or sustain
profitability in the future.
RESULTS OF OPERATIONS
The following table sets forth the percentage of the Company's revenue and
total expenses represented by certain line items from the Company's statement of
operations.
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
1994 1995 1996
-----------------------
<S> <C> <C> <C>
Revenue 100% 100% 100%
Costs and expenses:
Cost of revenue 60 77 103
Sales and marketing 17 34 73
General and administrative 22 52 49
Depreciation and amortization 4 12 18
----------------------
Total expenses 103 175 243
----------------------
Loss from operations (3) (75) (143)
Interest expense, net (2) (3) (7)
-----------------------
Loss before income taxes (5) (78) (150)
Income taxes -- -- --
----------------------
Net Loss (5)% (78)% (150)%
======================
</TABLE>
YEAR ENDED DECEMBER 31, 1996 COMPARED WITH YEAR ENDED DECEMBER 31, 1995
REVENUE
The Company derives its revenue from providing a comprehensive range of
Internet solutions, including Business connectivity, Web Site management and
security and other network products. Revenue grew 207% from $5.1 million in
1995 to $15.6 million in 1996, the majority of which was due to the change in
the Company's strategy to focus exclusively on Business Customers, who generally
require high bandwidth connectivity, and the associated expansion of its sales
and marketing efforts, including the creation of a direct sales force, and to
the development of the Company's Web Site management business.
COST OF REVENUE
Cost of revenue consists primarily of local access costs, network
infrastructure, leased network backbone circuit costs, network operations and
support costs, and cost of equipment sales. Network operations and support costs
consist primarily of personnel expenses relating to the operation of the network
infrastructure, including monitoring network traffic and quality, and costs of
providing technical support to customers. Cost of revenue increased 311% from
$3.9 million in 1995 to $16.0 million in 1996. Cost of revenue increased as a
percentage of revenues from 77% in 1995 to 103% in 1996. The increase in cost
of revenue was primarily due to costs associated with the Company's change in
strategy to
20
<PAGE>
focus exclusively on Business Customers. These costs include the
hiring of additional personnel to support the Company's expanding customer base
and the higher support requirements of Business Customers as well as the
expansion of the network backbone, the establishment of a 24x7x365 NOC, and the
building of redundant facilities. For example, the Company's customer support
and network operations personnel increased from 53 at December 31, 1995 to 117
at December 31, 1996. The Company plans to continue to expand its network
through 1997, which in turn will continue to increase cost of revenue. As the
costs associated with this expansion have been and will be incurred by the
Company in anticipation of growth in its customer base, the Company believes
that, over time, cost of revenue as a percentage of revenues will decline as its
customer base expands. However, in 1997, the Company expects its contribution
margin to be insufficient to absorb expected levels of selling, general and
administrative cost.
SALES AND MARKETING
Sales and marketing costs consist primarily of salaries and expenses of sales
and marketing personnel, advertising and promotion and marketing materials.
Sales and marketing costs rose 564% from $1.7 million in 1995 to $11.4 million
in 1996. Sales and marketing costs increased as a percentage of revenues from
34% in 1995 to 73% in 1996. The increase in sales and marketing costs was
primarily due to the Company's change in strategy to focus exclusively on
Business Customers. The Company's prior business strategy required minimal sales
and marketing. The change in strategy required the hiring of additional sales
and marketing personnel (from 36 at December 31, 1995 to 143 at December 31,
1996) and the expansion of advertising and promotional activities and product
development efforts. In addition, the Company expects to focus in the near
term on increasing its subscriber base of high-end Web Site Management and
Business Connectivity customers, which will require it to increase and
accelerate its overall sales and marketing costs, as higher sales and marketing
costs are incurred in the first half of 1997 in order to capture high-end
customers more quickly. This effort is likely to have an adverse effect on
operating results, at least in the near term.
GENERAL AND ADMINISTRATIVE
General and administrative costs consist primarily of expenses associated with
the Company's management, accounting, finance and administrative functions.
General and administrative costs increased 187% from $2.6 million in 1995 to
$7.6 million in 1996. This increase in general and administrative expenses was
due primarily to the hiring of additional senior management, finance, accounting
and administrative personnel to support the Company's expanding operations. The
Company expects to hire additional personnel in anticipation of continued
expansion of its operations. General and administrative costs were also affected
by a $789,000 non-cash compensation charge in 1996 related to the grant of stock
options. In addition, based on options granted through December 31, 1996
additional compensation charges of $1.4 million will be reported as general and
administrative costs during the period January 1, 1997 through December 31,
1999. See Note 5 to the financial statements for additional information with
respect to compensation expense related to stock option grants. The increase in
the general and administrative costs resulted principally from the increase in
the Company's general and administrative staff from 17 at December 31, 1995 to
54 at December 31, 1996. The Company expects to hire additional personnel in
anticipation of continued expansion of its operations.
DEPRECIATION AND AMORTIZATION
Depreciation and amortization increased from $655,000 in 1995 to $2.9 million
in 1996. The increase in 1996 is a result of $10.8 million of additions to
property and equipment related to developing and expanding the Company's network
infrastructure.
INTEREST EXPENSE, NET
Interest expense, net increased from $155,000 in 1995 to $1.1 million in
1996. The increase in interest expense during the 1996 period was primarily due
to the Company's issuance of subordinated debentures in November 1995 and
February 1996 and increased equipment financing and capital lease obligations
incurred to finance network expansion and to fund working capital requirements.
21
<PAGE>
YEAR ENDED DECEMBER 31, 1995 COMPARED WITH YEAR ENDED DECEMBER 31, 1994
REVENUE
Revenue grew 222% from $1.6 million in 1994 to $5.1 million in 1995, the
majority of which was due to the change in the Company's strategy to focus
exclusively on Business Customers, who generally require high bandwidth
connectivity, and to a lesser extent the development of the Company's Web Site
management business. In addition, the equity financing in March 1995
contributed to this increase by allowing the Company to greatly expand its
customer acquisition effort by building a direct sales force. The Company's
Business connectivity and Web Site management customers expanded from
approximately 16 accounts at December 31, 1994 to approximately 360 accounts at
December 31, 1995.
COST OF REVENUE
Cost of revenue increased 312% from $0.9 million in 1994 to $3.9 million in
1995. Cost of revenue increased as a percentage of revenues from 60% in 1994 to
77% in 1995. The increase in cost of revenue was primarily due to costs
associated with the Company's change in strategy to focus exclusively on
Business Customers. These costs included the hiring of additional personnel to
support the Company's expanding customer base as well as the expansion of the
network backbone, the establishment of a 24x7x365 NOC, and the building of
redundant facilities. The Company's customer support and network operations
personnel increased from 21 at December 31, 1994 to 53 at December 31, 1995. The
increased use of the network and the increase in capital expenditures to expand
the network infrastructure created an increase in depreciation and amortization
expense during 1995.
SALES AND MARKETING
Sales and marketing costs rose 550% from $0.3 million in 1994 to $1.7 million
in 1995. Sales and marketing costs increased as a percentage of revenues from
17% in 1994 to 34% in 1995. The increase in sales and marketing costs was
primarily due to the Company's change in strategy to focus exclusively on
Business Customers. The Company's prior business strategy required minimal sales
and marketing. The Company's change in focus required the hiring of additional
sales and marketing personnel (from 8 at December 31, 1994 to 36 at December 31,
1995), expanding advertising and promotional activities and product development
efforts.
GENERAL AND ADMINISTRATIVE
General and administrative costs increased 677% from $0.3 million in 1994 to
$2.6 million in 1995. These costs increased as a percentage of revenues from
22% in 1994 to 52% in 1995. This increase in general and administrative
expenses was due primarily to the hiring of 12 additional senior management,
finance, accounting and administrative personnel to support the Company's
expanding operations. The Company expects to hire additional personnel in
anticipation of continued expansion of its operations. General and
administrative costs were also affected by a $475,000 non-cash compensation
charge in 1995
related to the grant of stock options and a $301,000 write-off of accounts
receivable in 1995 compared to no write-offs during 1994. See Note 5 to the
financial statements for additional information with respect to compensation
expense related to stock options. The Company's general and administrative
staff increased from 5 at December 31, 1994 to 17 at December 31, 1995.
DEPRECIATION AND AMORTIZATION
Depreciation and amortization increased from $84,000 in 1994 to $0.7 million
in 1995. The increase in 1995 is a result of the significant investments made
in developing and expanding the Company's network infrastructure.
22
<PAGE>
INTEREST EXPENSE
Interest expense increased from $24,000 in 1994 to $0.2 million in 1995. The
increase in interest expense during 1995 was primarily due to interest of
$112,000 on $2.0 million of subordinated debentures and an increase in equipment
financing and capital lease obligations incurred to finance network expansion
and to fund working capital requirements.
LIQUIDITY AND CAPITAL RESOURCES
The Company currently anticipates that the remaining proceeds of the Company's
1996 initial public offering, together with approximately $19 million of secured
lease financing and other financing arrangements and funds from operations, will
be sufficient to meet the Company's anticipated working capital, lease
commitments, network expansion and capital expenditure requirements in 1997.
However, the Company anticipates that it will seek to arrange additional public
or private debt or equity financing, including, potentially, additional
equipment financing, to afford the Company greater liquidity and flexibility.
Moreover, the Company may raise additional funds in the event that the Company's
estimates of operating losses and capital requirements change or prove
inaccurate or in order for the Company to respond to unanticipated competitive
pressures or to take advantage of unanticipated opportunities.
Operating activities consumed cash of $2.5 and $10.1 million in 1995 and 1996,
respectively, compared with positive cash flow from operations of $133,000 in
1994. The increase in cash used in operating activities in 1995 and 1996 was
primarily the result of higher net losses and increased costs relating to
expansion of the Company's network and organizational infrastructure, including
the hiring of additional management, marketing and sales, finance, accounting
and administrative personnel. Additionally, in June 1996, the Company entered
into a multi-year private network agreement with WinStar. As part of this
agreement, WinStar advanced $5.0 million in cash for connectivity services to be
provided under such agreement and warrants to purchase 240,000 shares of Common
Stock.
Net cash used in investing activities was $353,000, $1.4 million and $16.6
million in 1994, 1995 and 1996, respectively. The increase in cash used in
investing activities resulted from increased fixed asset purchases from $350,000
in 1994 to $1.2 million in 1995 to $10.8 million in 1996, made primarily to
support the expansion of the Company's network infrastructure.
Net cash provided by financing activities increased from $222,000 in 1994 to
$4.8 million in 1995 to $53.5 million in 1996. The increase in net cash
provided by financing activities from 1994 to 1995 was principally due to $2.0
million in proceeds from the issuance of 10% Subordinated Debentures and
detachable stock warrants as well as approximately $3.5 million in proceeds from
the issuance of Series A Mandatorily Redeemable Convertible Preferred Stock and
detachable stock warrants in 1995.
On October 22, 1996, the Company received $40.7 million in net proceeds from
the completion of its initial public offering for the sale of 4,500,000 shares
of common stock. On November 11, 1996 the underwriters of the Company's initial
public offering exercised their over-allotment option to purchase an additional
675,000 shares of common stock. The Company received net proceeds of $6.4
million as a result of the exercise of the option. Additionally, in 1996 the
Company received proceeds of $1.0 million from the issuance of 10% Subordinated
Debentures and detachable stock warrants and $5.0 million from the issuance of
Series B Mandatorily Redeemable Convertible Preferred Stock. These proceeds
were used for the continued expansion of network and Web Site management
facilities and to fund operating losses and working capital requirements
associated with the expansion of the Company's customer base. Additionally, the
proceeds were used for repayment of borrowings under a revolving line of credit
agreement and capital lease obligations. The increase in net cash provided by
financing activities from 1995 to 1996 is further attributable to the proceeds
received from issuance of long-term debt used for equipment purchases.
23
<PAGE>
ITEM 7. FINANCIAL STATEMENTS
DIGEX INCORPORATED
BALANCE SHEETS
<TABLE>
<CAPTION>
DECEMBER 31,
1995 1996
--------------------------------
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents $ 832,582 $ 32,666,881
Accounts receivable, less allowance of $50,000 in
1995 and $777,309 in 1996 908,572 3,220,102
Due from officers and employees - 78,693
Inventory and prepaid expenses 49,631 1,249,881
Deferred income taxes 7,681 7,681
--------------------------------
Total current assets 1,798,466 37,223,238
Property and equipment:
Computer equipment and software 3,439,014 20,302,021
Office furniture and equipment 152,805 1,099,319
Leasehold improvements 163,811 792,760
--------------------------------
3,755,630 22,194,100
Less accumulated depreciation and amortization 764,966 3,615,810
---------------------------------
2,990,664 18,578,290
Other assets 262,656 971,498
---------------------------------
Total assets $ 5,051,786 $ 56,773,026
=================================
LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)
Current liabilities:
Accounts payable and accrued expenses $ 959,528 $ 8,501,492
Deferred revenue 389,472 4,931,333
Current portion of capital lease obligations 858,765 2,842,517
Current portion of long-term debt - 895,653
10% Convertible Debentures, net of
discount of $588,835 in 1995 1,411,165 -
---------------------------------
Total current liabilities 3,618,930 17,170,995
Capital lease obligations, less current portion 821,709 4,878,146
Long-term debt - 1,018,452
Series A Mandatorily Redeemable Convertible
Preferred Stock, $1 par value; 70,000 shares
authorized; 45,455 shares issued and outstanding 2,138,889 -
Stockholders' equity (deficit):
Preferred stock, $1.00 par value: Authorized
shares--130,000 in 1995 and 3,000,000 in 1996;
Issued and outstanding shares--none in 1995 and
1996 - -
Common stock, $.01 par value:
Authorized shares--19,920,000 shares in 1995 and
47,000,000 in 1996; Issued and outstanding shares--
1,617,907 in 1995 and 11,285,387 in 1996 16,179 112,853
Additional paid-in capital 2,834,672 61,946,527
Accumulated deficit (4,378,593) (28,353,947)
---------------------------------
Total stockholders' equity (deficit) (1,527,742) 33,705,433
---------------------------------
Total liabilities and stockholders' equity (deficit) $ 5,051,786 $ 56,773,026
=================================
</TABLE>
See notes to financial statements
24
<PAGE>
DIGEX, INCORPORATED
STATEMENTS OF OPERATIONS
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
1994 1995 1996
-----------------------------------------
<S> <C> <C> <C>
Net revenue:
Business Internet services $1,577,609 $ 4,425,172 $ 13,632,321
Equipment sales - 650,144 1,941,072
-----------------------------------------
1,577,609 5,075,316 15,573,393
Costs and expenses:
Network operations 945,575 3,436,821 14,390,425
Cost of equipment sales - 458,123 1,630,745
Sales and marketing 263,075 1,710,234 11,358,553
General and administrative 339,372 2,637,131 7,575,019
Depreciation and amortization 83,948 655,177 2,854,779
-----------------------------------------
Total expenses 1,631,970 8,897,486 37,809,521
-----------------------------------------
Loss from operations (54,361) (3,822,170) (22,236,128)
Other income (expense):
Interest and other income - 72,002 497,020
Interest expense (23,693) (226,745) (1,565,752)
-----------------------------------------
(23,693) (154,743) (1,068,732)
-----------------------------------------
Loss before income taxes (78,054) (3,976,913) (23,304,860)
Income taxes (3,470) - -
-----------------------------------------
Net loss (81,524) (3,976,913) (23,304,860)
Accretion of Series A Mandatorily
Redeemable Convertible Preferred
Stock to redemption value - (338,698) (422,333)
-----------------------------------------
Net loss attributable to common
stockholders $ (81,524) $(4,315,611) $(23,727,193)
=========================================
Net loss per common share
attributable to common stockholders $ (0.01) $ (0.63) $ (3.68)
=========================================
Average common and common equivalent
shares outstanding (in thousands) 6,888 6,878 6,168
=========================================
</TABLE>
See notes to financial statements.
25
<PAGE>
DIGEX, INCORPORATED
STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT)
<TABLE>
<CAPTION>
ADDITIONAL
COMMON PAID-IN ACCUMULATED
STOCK CAPITAL DEFICIT TOTAL
------------------------------------------------------
<S> <C> <C> <C> <C>
BALANCE AT JANUARY 1, 1994 $ 17,179 $ - $ 18,542 $ 35,721
Issuance of 190,883 warrants to purchase common stock - 25,393 - 25,393
Net loss for 1994 - - (81,524) (81,524)
------------------------------------------------------
BALANCE AT DECEMBER 31, 1994 17,179 25,393 (62,982) (20,410)
Issuance of warrants to purchase 1,120,000 shares
of common stock for an aggregate exercise price
of $100, net of expenses of $262,756 - 1,650,459 - 1,650,459
Issuance of warrants to purchase 299,946 shares of
common stock for $0.25 per share - 682,378 - 682,378
Value of vested common stock options
granted to employees - 475,442 - 475,442
Accretion of Series A Mandatorily Redeemable
Convertible Preferred Stock to redemption value - - (338,698) (338,698)
Retirement of 100,000 shares of common stock (1,000) 1,000 - -
Net loss for 1995 - - (3,976,913) (3,976,913)
------------------------------------------------------
BALANCE AT DECEMBER 31, 1995 16,179 2,834,672 (4,378,593) (1,527,742)
Issuance of warrants to purchase 166,378 shares of
common stock for $0.25 per share - 361,872 - 361,872
Issuance of warrants to
purchase 240,000 shares of common stock for $3.75
per share - 228,000 - 228,000
Value of vested common stock options granted to
employees - 788,733 - 788,733
Accretion of Series A Mandatorily Redeemable Convertible
Preferred Stock to redemption value - - (422,333) (422,333)
Dividends on Series B Mandatorily Redeemable
Convertible Preferred Stock - - (248,161) (248,161)
Conversion of Series A and B Mandatorily Redeemable
Convertible Preferred Stock into 2,680,336
shares of common stock 26,803 10,643,567 - 10,670,370
Exercise of warrants to purchase 1,868,407 shares
of common stock, less 56,264 warrants tendered
in satisfaction of exercise price 18,121 68,791 - 86,912
Issuance of 4,500,000 shares of common stock for
$10.125 per share, net of offering expenses of
$4,845,827 45,000 40,671,673 - 40,716,673
Exercise by underwriters of overallotment option to
purchase 675,000 shares at $10.125 per share, net of
expenses of $478,406 6,750 6,349,219 - 6,355,969
Net loss for 1996 - - (23,304,860) (23,304,860)
------------------------------------------------------
BALANCE AT DECEMBER 31, 1996 $112,853 $61,946,527 $(28,353,947) $ 33,705,433
======================================================
</TABLE>
See notes to financial statements.
26
<PAGE>
DIGEX, INCORPORATED
STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
FOR THE YEAR ENDED DECEMBER 31,
1994 1995 1996
-----------------------------------------
<S> <C> <C> <C>
OPERATING ACTIVITIES:
Net loss $ (81,524) $(3,976,913) $(23,304,860)
Adjustments to reconcile net loss to net cash provided by (used
in) operating activities:
Depreciation and amortization 83,948 655,177 2,854,779
Amortization of debt discount charged to interest expense 11,659 107,277 950,707
Non-cash compensation recorded for vested stock option grants - 475,442 788,733
Deferred income taxes (25,540) - -
Changes in operating assets and liabilities:
Accounts receivable (65,868) (767,084) (2,311,530)
Inventory and prepaid expenses (41,926) (7,705) (1,200,250)
Cash overdraft (4,347) - -
Accounts payable and accrued expenses 163,461 751,199 7,571,964
Deferred revenue 79,976 236,423 4,541,861
Income taxes payable 13,229 (20,910) -
-----------------------------------------
Net cash provided by (used in) operating activities 133,068 (2,547,094) (10,108,596)
INVESTING ACTIVITIES:
Due from officers and employees (6,222) 24,124 (78,693)
Purchase of property and equipment (350,132) (1,199,160) (10,776,151)
Decrease (increase) in other assets 3,584 (261,156) (708,842)
-----------------------------------------
Net cash used in investing activities (352,770) (1,436,192) (11,563,686)
FINANCING ACTIVITIES:
Proceeds from issuance of common stock - - 47,072,642
Borrowings under revolving line of credit - - 1,166,745
Repayments under revolving line of credit - - (1,166,745)
Proceeds from issuance of long-term debt - - 2,077,648
Repayment of long-term debt - - (163,543)
Proceeds from issuance of (repayment of) notes
payable and detachable stock warrants 300,000 (300,000) -
Repayments of capital leases obligations - (415,080) (1,795,078)
Proceeds from issuance of 10% Subordinated
Debentures and detachable stock warrants - 2,000,000 1,000,000
Proceeds from issuance of Series A Mandatorily Redeemable
Convertible Preferred Stock and detachable
stock warrants, net of expenses of issuance - 3,528,507 -
Proceeds from issuance of Series B Mandatorily
Redeemable Convertible Preferred Stock - - 5,000,000
Proceeds from issuance of warrants to purchase
common stock to customer - - 314,912
Increase in deferred financing costs (77,857) - -
-----------------------------------------
Net cash provided by financing activities 222,143 4,813,427 53,506,581
-----------------------------------------
Net increase in cash and cash equivalents 2,441 830,141 31,834,299
Cash and cash equivalents at beginning of year - 2,441 832,582
-----------------------------------------
Cash and cash equivalents at end of year $ 2,441 $ 832,582 $ 32,666,881
=========================================
</TABLE>
See notes to financial statements.
27
<PAGE>
DIGEX, INCORPORATED
NOTES TO FINANCIAL STATEMENTS
1. DESCRIPTION OF BUSINESS AND SIGNIFICANT ACCOUNTING POLICIES
Description of Business
DIGEX, Incorporated (the ''Company''), is a national Internet access carrier.
The Company's principal customers are businesses, government agencies and other
institutional customers. The services provided by the Company include business
connectivity, Web server hosting, individual dial-up network access, and
security and other network products.
Use of Estimates
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the amounts reported in the financial statements and accompanying notes.
Actual results could differ from those estimates.
Cash Equivalents
The Company considers all short-term, highly liquid investments with
maturities of three months or less when purchased to be cash equivalents.
Inventory
Inventory, consisting primarily of computer equipment, is stated at the lower
of first-in, first-out cost, or market.
Property and Equipment
Property and equipment is stated at cost. Depreciation is computed for owned
assets using the straight-line method over estimated useful lives of five years.
Assets capitalized under capital leases are amortized using the straight-line
method over the lesser of the lease term or the useful life of the asset.
Other Assets
Other assets consist primarily of security deposits on leased computer
equipment and office furniture and equipment. The deposits will be applied
against the final month's lease payments.
Revenue Recognition and Accounts Receivable
The Company offers annual subscriptions to its customers for Internet access
and also may arrange for advance payments under contracts to deliver business
connectivity services. Advance payments for these services are deferred and
recognized in the periods in which the services are performed. Equipment sales
are recognized upon shipment. Receivables generally are due within 30 days. The
Company does not generally require collateral from its customers.
Advertising Costs
The Company expenses advertising costs as incurred. Advertising expense
totaled $24,600, $488,900, and $1,631,100 in 1994, 1995 and 1996, respectively.
28
<PAGE>
DIGEX, INCORPORATED
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
1. DESCRIPTION OF BUSINESS AND SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
Stock Options Granted to Employees
The Company records compensation expense for all stock-based compensation
plans using the intrinsic value method prescribed by APB Opinion 25, Accounting
for Stock Issued to Employees. In October 1995, the Financial Accounting
Standards Board issued FASB Statement No. 123, Accounting for Stock-Based
Compensation, which encourages companies to recognize expense for stock-based
awards based on their estimated value on the date of grant. Statement 123,
effective for 1996, does not require companies to change their existing
accounting for stock-based awards, but if the new fair value method is not
adopted, pro forma income and earnings per share data should be provided in the
notes to the financial statements. The Company has supplementally disclosed in
Note 5 the required pro forma information as if the fair value method had been
adopted.
Income Taxes
The Company uses the liability method in accounting for income taxes. Under
this method, deferred tax assets and liabilities are determined based on
differences between financial reporting and tax bases of assets and liabilities
and are measured using the enacted tax rates and laws that will be in effect
when the differences are expected to reverse.
Reclassifications
Certain amounts in the 1994 and 1995 statements of operations have been
reclassified to conform with the 1996 presentation.
2. AGREEMENT WITH CUSTOMER
In June 1996, the Company entered into a six-year private network agreement
with WinStar Communications, Inc. As part of the agreement, WinStar will
purchase $5 million of connectivity services which was paid in advance in June
1996. WinStar also received warrants to purchase 240,000 shares of common stock
for $3.75 per share. The warrants were valued at $228,000, or $0.95 per share,
based on an independent valuation of the Company's common stock and the use of a
generally accepted warrant valuation methodology. The estimated value of the
warrants was recorded as additional paid-in capital of $228,000 and deferred
revenue associated with the contract was initially recorded in the amount of
$4,772,000. At December 31, 1996, the balance of deferred revenue related to
this agreement was $4,383,000.
3. LEASES
Capital Leases
The Company leases equipment under capital leases. Property and equipment
includes the following amounts for leases that have been capitalized:
<TABLE>
<CAPTION>
DECEMBER 31, 1995 DECEMBER 31, 1996
--------------------------------------
<S> <C> <C>
Computer equipment $1,985,436 $9,679,319
Office furniture and 110,118 110,118
equipment
--------------------------------------
2,095,554 9,789,437
Less accumulated 444,683 2,213,564
amortization --------------------------------------
$1,650,871 $7,575,873
======================================
</TABLE>
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
29
<PAGE>
DIGEX, INCORPORATED
3. LEASES (CONTINUED)
Capital Leases (continued)
Amortization of leased assets is included in depreciation and amortization
expense.
Future minimum payments under capital lease obligations consist of the
following at December 31, 1996:
<TABLE>
<CAPTION>
<S> <C>
1997 $3,492,955
1998 3,054,273
1999 2,107,585
2000 399,690
----------
Total minimum lease payments 9,054,503
Less amounts representing interest 1,333,840
----------
Present value of net minimum lease
payments (including current
portion of $2,842,517) $7,720,663
==========
</TABLE>
Operating Leases
The Company leases certain office space and equipment under noncancelable
operating leases that expire in various years through 2001. Future minimum
payments under noncancelable operating leases with initial terms of one year or
more consisted of the following at December 31, 1996:
<TABLE>
<CAPTION>
<S> <C>
1997 $ 810,771
1998 677,661
1999 539,158
2000 317,686
2001 19,525
-------------
Total minimum lease payments $2,364,801
=============
</TABLE>
Rental expense consisted of the following:
<TABLE>
<CAPTION>
1994 1995 1996
---------------------------------------
<S> <C> <C> <C>
Office and storage $19,200 $123,749 $ 407,913
Furniture and equipment 28,915 133,889 536,502
---------------------------------------
$48,115 $257,638 $ 944,415
=======================================
</TABLE>
4. LONG-TERM DEBT
<TABLE>
<CAPTION>
<S> <C>
Long-term debt consists of the following at December 31, 1996:
Note payable bearing interest at 10.07%, maturing in monthly installments through
November 1999, and secured by equipment $1,119,458
Note payable bearing interest at 10.00%, maturing in monthly installments through
April 1998, and secured by equipment 666,070
Other notes payable, principally at 10% due through November 2001 128,577
----------
1,914,105
Less current maturities 895,653
----------
$1,018,452
==========
</TABLE>
30
<PAGE>
DIGEX, INCORPORATED
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
4. LONG-TERM DEBT (CONTINUED)
Maturities of long-term debt are as follows:
<TABLE>
<CAPTION>
Year ending December 31,
<S> <C>
1997 $ 895,994
1998 622,390
1999 384,323
2000 5,812
2001 5,586
----------
$1,914,105
==========
</TABLE>
The note payable with a balance of $666,070 at December 31, 1996 requires the
maintenance of a compensating cash balance of at least $5,000,000.
The estimated fair value of long-term debt at December 31, 1996 approximates
its carrying value.
5. STOCK OPTIONS
In 1995, the Company approved and adopted its 1995 Stock Option Plan. In
1996, the Company approved and adopted its 1996 Equity Participation Plan. The
Plans are administered by the Board of Directors. The Plans provide for the
granting of either qualified or non-qualified options to purchase an aggregate
of up to 2,500,480 shares of common stock to eligible employees, officers,
directors and consultants of the Company. The 1996 Equity Participation Plan
also provides for the granting of other equity participation instruments.
The following table summarizes the option activity under the Plans for the two
year period ended December 31, 1996:
<TABLE>
<CAPTION>
SHARES WEIGHTED AVERAGE
OUTSTANDING EXERCISABLE EXERCISE PRICES
----------------------------------------------------------
<S> <C> <C> <C>
Balances at January 1, 1995 - - --
Granted 632,280 - $0.25
Became exercisable - 188,280 $0.25
Canceled (2,050) - $0.25
------------------------------
Balances at December 31, 1995 630,230 188,280 $0.25
Granted 1,924,540 - $5.42
Became exercisable - 353,535
Exercised (4,300) $0.25
Canceled (41,145) $3.81
------------------------------
Balances at December 31, 1996 2,509,325 541,815
------------------------------
Weighted average exercise price of options
exercisable at December 31, 1996 $ 1.08
========
Weighted average exercise price of options
outstanding at December 31,1996 $4.16
=========
</TABLE>
31
<PAGE>
DIGEX, INCORPORATED
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
5. STOCK OPTIONS (CONTINUED)
Exercise prices for options outstanding as of December 31, 1996 ranged from
$0.25 to $10.38 as follows:
<TABLE>
<CAPTION>
WEIGHTED
OPTIONS EXERCISE PRICE AVERAGE
OUTSTANDING REMAINING
CONTRACTUAL LIFE
------------------------------------------------
<S> <C> <C>
1,087,239 $ 0.25 8.9 years
660,286 $ 3.73 9.4 years
565,100 $10.00 9.5 years
196,700 $10.38 9.9 years
</TABLE>
All of the options granted through December 31, 1996 are non-qualified stock
options and vest over 3 or 4 years. At the dates of grant, the estimated fair
value of a share of the Company's common stock ranged from $2.28 to $10.00. The
Company will record compensation expense of $2,658,439 over the vesting period
of the options. For the years ended December 31, 1995 and 1996, the Company
recorded $475,442 and $788,733 of compensation expense, respectively. The
Company will record additional compensation expense related to option grants
through December 31, 1996 as follows:
<TABLE>
<CAPTION>
<S> <C>
1997 $ 747,161
1998 527,628
1999 119,475
--------------------
Total $1,394,264
==========
</TABLE>
For the years ended December 31, 1995 and 1996, pro forma net income and
earnings per share information required by Statement 123 has been determined
using the fair value method. The fair value of these options was estimated at
the date of grant using a Black-Scholes option pricing model with the following
weighted average assumptions: risk-free interest rate of 5.50%, dividend yield
of 0%, volatility factors of the expected market price of the Company's common
stock of .01 and .467 for options granted prior to and after the public
offering, respectively, and an expected life of granted options which varies
from three to four years depending upon the vesting period. The weighted-
average grant-date fair value of options granted during 1996 was $2.25 for
options granted with an exercise price less than the estimated fair value of the
common stock on the grant date and $1.40 for options granted with an exercise
price equal to the market price of the common stock on the grant date.
The Black-Scholes option valuation model was developed for use in estimating
the fair value of traded options which have no vesting restrictions and are
fully transferable. In addition, option valuation models require the input of
highly subjective assumptions including the expected stock price volatility.
Because the Company's employee stock options have characteristics significantly
different from those of traded options and because changes in the subjective
input assumptions can materially affect the fair value estimate, in management's
opinion, the existing models do not necessarily provide a reliable single
measure of the fair value of its employee stock options.
For purposes of pro forma disclosures, the estimated fair value of the options
is amortized to expense over the options' vesting period. The Company's pro
forma net loss is $(4,470,366) and $(24,313,365) for the years ended December
31, 1995 and 1996, respectively. Pro forma loss per share attributable to
common stockholders is $(0.70) and $(4.01) for the years ended December 31, 1995
and 1996, respectively. The effect of compensation expense from stock options on
1995 pro forma net loss reflects only the vesting of 1995 awards and the first
year of vesting of the 1996 awards. However, 1996 pro forma net loss reflects
the second year of vesting of the 1995 awards. Because the granted stock
options vest over a 3 or 4 year period, not until 1998 is the full
32
<PAGE>
DIGEX, INCORPORATED
NOTES TO THE FINANCIAL STATEMENTS (CONTINUED)
5. STOCK OPTIONS (CONTINUED)
the 1995 awards and the first year of vesting of the 1996 awards. Because the
granted stock options vest over a 3 or 4 year period, not until 1998 is the full
effect of recognizing compensation expense for stock options representative of
the possible effects on pro forma net income for future years.
6. 10% CONVERTIBLE DEBENTURES AND DETACHABLE STOCK WARRANTS
In November 1995 the Company issued $2,000,000 of 10% Convertible Debentures
("the Debentures") with detachable stock warrants to purchase 299,946 shares of
common stock at an exercise price of $0.25 per share for cash proceeds of
$2,000,000. In February 1996 the Company issued an additional $1,000,000 of the
Debentures with detachable stock warrants to purchase 166,378 shares of common
stock at an excercise price of $0.25 per share for cash proceeds of $1,000,000.
Upon issuance of the Debentures, the warrants were valued based on an
independent valuation of the Company's common stock and the use of a generally
accepted warrant valuation methodology. The estimated value of the warrants was
recorded as additional paid-in capital and the Debentures were recorded net of
the corresponding discount.
In May 1996 the Debentures were converted into Series B Preferred Stock. In
October 1996, upon the closing of the Company's initial public offering, all of
the outstanding Series B Preferred Stock and all of the warrants issued in
connection with the Debentures were exercised or converted into common stock.
7. SERIES A MANDATORILY REDEEMABLE CONVERTIBLE PREFERRED STOCK, SERIES B
MANDATORILY REDEEMABLE PREFERRED STOCK AND DETACHABLE STOCK WARRANTS
In 1995 the Company issued 45,455 shares of Series A Mandatorily Redeemable
Convertible Preferred Stock ("Series A") with detachable stock warrants for cash
proceeds of $4,000,000. The detachable stock warrants entitled the holders to
purchase 1,120,000 shares of common stock for an aggregate purchase price of
$100. These warrants were valued at $1,913,215, or $1.71 per share, based on an
estimate at the date of the transaction of the relative value of the Series A
and the warrants. The costs of issuance of $549,350 were deducted
proportionately from the proceeds allocated to the warrants and the Series A.
Charges to retained earnings were recorded during the period the Series A was
outstanding to accrete the Series A to its redemption value using the interest
method.
In connection with the issuance of the Series A, the Company also issued
warrants to purchase 91,200 shares of common stock with an exercise price of
$2.63 per share to its investment bankers.
The Series A converted into 500,000 shares of common stock upon the closing of
the Company's initial public offering in October 1996. The holders of the
warrants issued in connection with the Series A also exercised all of the
warrants in exchange for 1,211,200 shares of common stock.
In May 1996, the Company issued 50,000 shares of Series B Mandatorily
Redeemable Preferred Stock ("Series B") for $5,000,000. Also in May 1996, and
as described in Note 6, holders of the Debentures with a face value of
$3,000,000 converted the Debentures into 31,264 shares of Series B. Upon the
closing of the Company's initial public offering in October 1996, the total
outstanding shares of Series B of 81,264 converted into 2,180,366 shares of
common stock.
33
<PAGE>
DIGEX, INCORPORATED
NOTES TO THE FINANCIAL STATEMENTS (CONTINUED)
8. COMMON STOCK
In March 1995, the Company amended and restated the Articles of Incorporation
to authorize the issuance of 49,800,000 shares of $.01 par value common stock
and 200,000 shares of $1 par value Series A Mandatorily Redeemable Convertible
Preferred Stock with a redemption price and liquidation value of $100 per share.
In conjunction with the amendment, the Board of Directors approved a 505.26-for-
1 stock split, effected in the form of a stock dividend. In August 1995, the
Board of Directors approved a 10-for-1 stock split, also effected in the form of
a stock dividend. In October 1996, the Board of Directors approved a 1- for -2.5
reverse stock split in connection with the Company's initial public offering of
common stock. All share and per share amounts in the accompanying financial
statements have been restated to retroactively reflect all splits.
9. LOSS PER SHARE
The following table summarizes the computations of share amounts used in the
computation of loss per share presented in the accompanying statements of
operations (in thousands of shares):
<TABLE>
<CAPTION>
YEAR ENDED
DECEMBER 31,
---------------------
1994 1995 1996
---------------------
<S> <C> <C> <C>
Weighted average number of shares of common 1,718 1,708 3,583
stock outstanding during the period
Effect of options and warrants to purchase
common stock issued within one year of
registration statement 2,990 2,990 1,495
Effect of convertible debentures and preferred
stock issued within one year of registration
statement 2,180 2,180 1,090
--------------------
Total common and common equivalent shares of
stock considered outstanding during the year 6,888 6,878 6,168
--------------------
</TABLE>
Loss per share is based upon the average number of shares of common stock
outstanding during each period. As required by the Securities and Exchange
Commission, all common stock warrants, options, convertible debentures, and
convertible preferred stock issued by the Company at exercise prices or
conversion rates below the expected public offering price during the twelve-
month period prior to the initial public offering date have been included in the
computations as if they were outstanding for all periods included in the initial
public offering registration statement, which included the first six months of
1996, even if the result was anti-dilutive.
Accordingly, the computation of loss per share in 1996 includes the anti-
dilutive effect of the securities issued within one year of the initial public
offering registration statement for only six months, or the interim period in
1996 included in the initial public offering registration statement. These
securities are not considered outstanding for the last six months of 1996 as the
effect on the computation is anti-dilutive.
For purposes of computing net loss per common share attributable to common
stockholders for the twelve months ended December 31, 1996, the net loss was
reduced by $1,058,466 of interest expense attributable to the Debentures which
converted into Series B during the period.
34
<PAGE>
DIGEX, INCORPORATED
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
10. INCOME TAXES
Significant components of the Company's deferred tax assets and liabilities
are as follows:
<TABLE>
<CAPTION>
1995 1996
----------------------------
<S> <C> <C>
Deferred tax liability:
Tax over book depreciation $ 49,581 $ 422,631
Deferred tax assets:
Net operating loss carryforward 1,382,447 8,431,204
Allowance for doubtful accounts 19,310 300,197
Stock option compensation expense 183,615 488,224
Accrued bonuses 23,172 -
Networth agreement deferred revenue - 1,692,715
Charitable Contributions - 2,377
----------------------------
Total deferred tax assets 1,608,544 10,914,717
----------------------------
Net future income tax benefit 1,558,963 10,492,086
----------------------------
Valuation allowance for net deferred tax assets (1,551,282) (10,484,405)
----------------------------
Net deferred tax assets $ 7,681 $ 7,681
============================
</TABLE>
As of December 31, 1996, the Company had net operating loss carryforwards of
approximately $21,800,000. These carryforwards expire through 2011. At the
initial public offering date, the Company underwent a change in control for
federal income tax purposes. It is not expected that this ownership change will
materially limit the future use of net operating loss carryforwards.
The Company's provision for income taxes resulted in effective tax rates that
varied from the statutory federal income tax rate as follows:
<TABLE>
<CAPTION>
1994 1995 1996
--------------------------------------
<S> <C> <C> <C>
Expected federal income tax benefit at 34% $(26,538) $(1,352,150) $(7,923,652)
State income tax benefit, net of federal expense (3,606) (183,733) (1,076,685)
Expenses not deductible for tax purposes 4,357 3,602 42,524
Effect of valuation allowance 17,723 1,533,559 8,933,122
Other 11,534 (1,278) 24,691
--------------------------------------
Total $ 3,470 $ - $ -
======================================
</TABLE>
11. EMPLOYEE BENEFIT PLAN
The Company established a defined contribution benefit plan effective July 1,
1995. The plan covers substantially all employees who have three months of
service with the Company or who were employed by the Company on July 1, 1995.
Participants may contribute from 1% to 15% of their annual compensation to the
plan. In addition, the Company may make discretionary profit-sharing
contributions to the plan. No contributions were made by the Company during 1995
or 1996.
12. SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION
<TABLE>
<CAPTION>
1994 1995 1996
-------------------------------
<S> <C> <C> <C>
Cash paid during the period for:
Interest $ - $ 105,100 $ 507,752
Taxes - - -
Non-cash investing and financing activities:
Equipment acquired under capital lease - 2,095,600 9,789,437
</TABLE>
35
<PAGE>
DIGEX, INCORPORATED
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
13. SUBSEQUENT EVENT
On January 3, 1997, the Company acquired all of the assets of Electronics
Press Services Group (EPSG) for approximately $805,000 in cash and the
assumption of approximately $20,000 in liabilities. Additionally, the Company
issued to the sellers warrants to purchase 175,000 shares of common stock.
These warrants are exercisable at any time during the period from December 31,
1997 through January 1, 2000 at $10.38 per share. The acquisition was accounted
for as a purchase and resulted in the recording of approximately $613,000 of
goodwill that will be amortized over 10 years
EPSG designs, integrates and manages electronic commerce solutions for
corporate Internet Web sites. The acquisition of EPSG is an element of the
Company's heightened focus on and evolving commitment to the most critical and
highest revenue-producing customers, such as software publishers and
mission-critical applications with high access and reliability requirements.
Further investments in this strategy are comtemplated.
36
<PAGE>
DIGEX, INCORPORATED
REPORT OF INDEPENDENT AUDITORS
The Board of Directors and Stockholders
DIGEX, Incorporated
We have audited the accompanying balance sheets of DIGEX, Incorporated as of
December 31, 1995 and 1996, and the related statements of operations,
stockholders' equity (deficit) and cash flows for each of the three years in the
period ended December 31, 1996. These financial statements are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the financial position of DIGEX, Incorporated at December
31, 1995 and 1996, and the results of its operations and its cash flows for each
of the three years in the period ended December 31, 1996 in conformity with
generally accepted accounting principles.
/s/ Ernst & Young LLP
Baltimore, Maryland
February 24, 1997
37
<PAGE>
PART II (CONTINUED)
ITEM 8. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURES
Not applicable.
PART III
ITEM 9. DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS;
COMPLIANCE WITH SECTION 16(A) OF THE EXCHANGE ACT
The information called for by Item 9 is incorporated by reference to the
information under the caption "Election of Directors" in the Company's
definitive proxy statement which will be filed with the Securities and Exchange
Commission pursuant to Regulation 14A not later than April 30, 1997.
ITEM 10. EXECUTIVE COMPENSATION
The information called for by Item 10 is incorporated by reference to the
information under the caption "Executive Compensation and Other Information" in
the Company's definitive proxy statement, which will be filed with the
Securities and Exchange Commission pursuant to Regulation 14A not later than
April 30, 1997.
ITEM 11. SECURITY OWNERSHIP AND CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information called for by Item 11 is incorporated by reference to the
information under the captions "Equity Securities and Certain Holders thereof"
and "Election of Directors" in the Company's definitive proxy statement, which
will be filed with the Securities and Exchange Commission pursuant to Regulation
14A not later than April 30, 1997.
ITEM 12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information called for by Item 12 is incorporated by reference to the
information under the captions "Election of Directors" and "Other Relationships"
in the Company's definitive proxy statement, which will be filed with the
Securities Exchange Commission pursuant to Regulation 14A not later than April
30, 1997.
38
<PAGE>
PART IV.
ITEM 13. EXHIBITS AND REPORTS ON FORM 8-K
<TABLE>
<CAPTION>
A. EXHIBITS
<C> <S>
EXHIBIT NO. DESCRIPTION OF EXHIBIT
- -----------------------------------------------------
3.1* Amended and Restated Certificate of
Incorporation of the Registrant.
3.2* Restated By-Laws of the Registrant.
4.1* Form of Common Stock certificate.
10.1* MCI Special Customer Arrangement
between MCI Telecommunications
Corporation and Digital Express Group,
Inc. dated March 28, 1996. (1)
10.2* Customer contract with LCI
International, Inc. dated May 29, 1996. (1)
10.3* Customer contract with WinStar
Communications, Inc. dated June 6, 1996.
10.4* Warrant agreement with WinStar
Communications, Inc. dated June 6, 1996.
10.5 Peering Agreements
*(a) Agreement for T1 Gateway
Attachment Services, as amended, with
ANS CO+RE Systems Inc. dated February
1, 1994. (1)
*(b) Bilateral Interconnection
Agreement with PSI Net Inc. dated
February 7, 1996.
*(c) Peering Agreement with MCI
Telecommunications Corporation dated
April 21, 1995.
10.6* Agreement with Hughes Network Systems,
Inc. dated June 7, 1996.
10.7* Lease agreement with Banbury Associates
Limited Partnership dated November 17,
1994.
10.8* Lease Agreement with George
Christancos, dated December 4, 1996.
10.9* Lease Agreement with Executive Office
Network, Ltd.
10.10* Sublease Agreement with A.S. McGaughaan.
10.11* Employment and consulting agreements
(a) Clyde A. Heintzelman, dated March
19, 1995.
(b) Christopher R. McCleary, dated
February 1, 1996.
(c) Brian M. Deobald, dated March 25,
1996.
(d) Earl P. Galleher, dated March 25,
1996.
(e) Nicholas J. Magliato, dated March
25, 1996.
(f) William A. Pendley, dated April
1, 1996.
(g) Thomas M. Brandt, Jr. Dated June
1, 1996.
10.12* Incentive Stock Option Plan.
10.13* Securities Purchase Agreement with
Grotech Partners IV, L.P., Venrock
Associates, Southern Venture Fund II,
L.P., Douglas E. Humphrey and Michael
T. Doughney dated March 24, 1995.
10.14* Stockholders Agreement with Grotech
Partners IV, L.P., Venrock Associates,
Southern Ventures II, L.P. Douglas E.
Humphrey and Michael T. Doughney dated
March 24, 1995.
10.15* (a) Warrant Agreement with Grotech
Partners IV, L.P. dated March 24, 1995.
(b) Warrant Agreement with Venrock
Associates dated March 24, 1995.
(c) Warrant Agreement with Southern
Venture Fund II, L.P. dated March 24,
1995.
10.16* Loan and Security Agreement with
Silicon Valley Bank dated April 11,
1996.
10.17* First Amendment to Loan and Security
Agreement with Silicon Valley Bank
dated May 1996.
10.18* Revolving Promissory Note with Silicon
Valley Bank dated April 11, 1996.
10.19* Securities Purchase, Conversion and
Exchange Agreement with Grotech
Partners IV, L.P., Grotech Partners
III, L.P., Grotech III Companion Fund,
L.P., Grotech III Pennsylvania Fund,
L.P., Venrock Associates, Venrock
Associates II, L.P., Southern Venture
Fund II, L.P., Blue Chip Capital Fund
Limited Partnership, Crisler Capital
Company, Limited Partnership dated May
30, 1996.
10.20* Series C Subordinated Convertible
Debentures Agreement of September 27,
1996
10.21* Promissory Note with Blue Chip Capital
Fund Limited Partnership, dated October
7, 1996
10.22* Form of Warrant agreement with Blue
Chip Capital Fund Limited Partnership
11.1 Statement of Computation of per share
earnings (information provided in Note
9 of the audited financial statements
23.1 Consent of Ernst & Young LLP (included
herein)
24.1 Power of Attorney (included herein on page 40)
27 Financial Data Schedule (included herein)
- -----------
</TABLE>
* Incorporated by reference to the exhibit of the same number from the
Company's Registration Statement on Form SB-2, File No. 333-05871.
(1) Subject to a request for confidential treatment; the entirety of this
exhibit has been filed separately with the Securities and Exchange
Commission.
A. REPORTS ON FORM 8-K
The Company filed no Reports on Form 8-K during the year ended December 31,
1996.
39
<PAGE>
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, as amended, the Registrant has duly caused this report to be signed
on its behalf by the undersigned, thereunto duly authorized.
DIGEX, INCORPORATED
Date: March 31, 1997 By /s/ Christopher R. McCleary
Christopher R. McCleary -------------------------------------------
Chairman of the Board, President and
Chief Executive Officer
Date: March 31, 1997 By /s/ John C. Welling
-------------------------------------------
John C. Welling
Vice President, Chief Financial Officer,
Controller and Secretary
KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears
below constitutes and appoints Christopher R. McCleary and John C. Welling and
both of them, as his attorney-in-fact, with full power of substitution, for him
in any and all capacities, to sign any amendments to this Report on Form 10-KSB
and to file the same, with exhibits thereto and other documents in connection
therewith, with the Securities and Exchange Commission, hereby ratifying and
confirming all that said attorney-in-fact, or his substitute or substitutes, may
do or cause to be done by virtue hereof.
In accordance with the Exchange Act, this report has been signed below by the
following persons on behalf of the registrant and in the capacities and on the
dates indicated.
SIGNATURE TITLE DATE
--------- ----- ----
/s/ Christopher R. McCleary Chief Executive Officer, March 31, 1997
- --------------------------- President and Chairman
Christopher R. McCleary of the Board (principal
executive officer)
/s/ John C. Welling Vice President, Chief March 31, 1997
- ---------------------------- Financial Officer,
John C. Welling Controller and
Secretary (principal
accounting officer)
/s/ Douglas E. Humphrey Senior Vice President, March 31, 1997
- --------------------------- Director
Douglas E. Humphrey
/s/ Frank A. Adams Director March 31, 1997
- ---------------------------
Frank A. Adams
/s/ Thomas H. Cato Director March 31, 1997
- ---------------------------
Thomas H. Cato
40
<PAGE>
/s/ William F. Earthman, III Director March 31, 1997
- ----------------------------
William F. Earthman, III
/s/ Ray A. Rothrock Director March 31, 1997
- ----------------------------
Ray A. Rothrock
/s/ Robert M. Stewart Director March 31, 1997
- ----------------------------
Robert M. Stewart
/s/ John H. Waynt Director March 31, 1997
- ---------------------------
John H. Wyant
41
<PAGE>
EXHIBIT 23
INDEPENDENT AUDITORS
We consent to the incorporation by reference in the Registration Statement (Form
S-8 No. 333-17429) pertaining to the 1995 Stock Option Plan, the 1996 Equity
Participation Plan and the 1997 Employee Stock Purchase Plan of DIGEX,
Incorporated, of our report dated February 24, 1997, with respect to the
financial statements of DIGEX, Incorporated included in the Annual Report (form
10-KSB) for the year ended December 31, 1996.
/s/ Ernst & Young LLP
Baltimore, Maryland
March 26, 1997
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<MULTIPLIER> 1,000
<S> <C> <C>
<PERIOD-TYPE> YEAR YEAR
<FISCAL-YEAR-END> DEC-31-1995 DEC-31-1996
<PERIOD-START> JAN-01-1995 JAN-01-1996
<PERIOD-END> DEC-31-1995 DEC-31-1996
<CASH> 0 0
<SECURITIES> 0 0
<RECEIVABLES> 0 0
<ALLOWANCES> 0 0
<INVENTORY> 0 0
<CURRENT-ASSETS> 0 0
<PP&E> 0 0
<DEPRECIATION> 655,177 2,854,779
<TOTAL-ASSETS> 5,051,786 56,773,026
<CURRENT-LIABILITIES> 3,618,930 17,170,995
<BONDS> 0 0
2,138,889 0
0 0
<COMMON> 16,179 112,853
<OTHER-SE> (1,543,921) (33,592,580)
<TOTAL-LIABILITY-AND-EQUITY> 5,051,786 56,773,026
<SALES> 5,075,316 15,573,393
<TOTAL-REVENUES> 5,075,316 15,573,393
<CGS> 458,123 1,630,745
<TOTAL-COSTS> 8,897,486 37,809,521
<OTHER-EXPENSES> 0 0
<LOSS-PROVISION> 0 0
<INTEREST-EXPENSE> 226,745 1,565,752
<INCOME-PRETAX> (3,976,913) (23,304,860)
<INCOME-TAX> 0 0
<INCOME-CONTINUING> (3,822,170) (22,236,128)
<DISCONTINUED> 0 0
<EXTRAORDINARY> 0 0
<CHANGES> 0 0
<NET-INCOME> (3,976,913) (23,304,860)
<EPS-PRIMARY> (.63) (3.68)
<EPS-DILUTED> 0 0
</TABLE>
